Macro Economics

NATIONAL OPEN UNIVERSITY OF NIGERIA
SCHOOL OF BUSINESS AND HUMAN RESOURCE

MANAGEMENT
COURSE CODE: ENT 108
COURSE TITLE: MICRO ECONOMICS
ENT 108
MACRO-ECONOMICS
COURSE
GUIDE
ENT 108
MACRO-ECONOMICS
Course Developer/Writer Abdullahi S. Araga
National Open University of Nigeria
Programme Leader
Dr. O. J. Onwe
Course Coordinator
Mrs. E. A. Adegbola

ii
ENT 108
MACRO-ECONOMICS

Headquarters
14/16 Ahmadu Bello Way
Victoria Island
Lagos
Abuja Office
No. 5 Dar es Salaam Street
Off Aminu Kano Crescent
Wuse II, Abuja
Nigeria
e-mail: centralinfo@nou.edu.ng
URL: www.nou.edu.ng
Published by

Printed 2009
ISBN: 978-058-391-2
All Rights Reserved
iii
ENT 108
CONTENTS
MACRO-ECONOMICS
PAGE
Introduction.
Course Contents...
Course Aims....
Course Objectives....
Course Materials.....
Study Units.
Assignments.......
Tutor-Marked Assignment.
Final Examination and Grading.
Summary..
1
1
1
2
3
3
4
4
4
4
Introduction
ENT 108: Macro-economics is a semester course work of two credit
hours. It is available to all the students, taking the B.Sc. Programme in
Entrepreneurial and Small Business Management in the School of
Business and Human Resources Management.
This course consists of 15 units comprising the nature of national
income, consumption, saving and investment, multiplier, accelerator and
aggregate level of employment, inflation and deflation, international
financial and economic institutions, monetary and fiscal policy,
unemployment, demand and supply of money, financial institutions, and
balance of trade and balance of payments.
The course is designed to give students an in-depth understanding of the
nature of macroeconomics and the role macroeconomics variables play
in the operations of the economy. The in-depth coverage of the course is
to enable students appreciate the working mechanism of the economy, in
terms of the effect of the interplay of macroeconomics variables on the
economy. Furthermore, the course is also intended to enable students to
understand the role such macroeconomics variables play in ameliorating
the many economic problems in the society.
This Course Guide tells you what ENT 108: Macro-economics is all
about in terms of the nature of the material. How to use the contents of
the material is spelt out for adequate knowledge and eventual success in
the course. Other information provided in the course includes: how to
make use of your time in the course, self-assessment questions, tutormarked assignments, etc. There will also be tutorial classes. Full details
concerning the tutorial classes will be conveyed to you at the
appropriate time.
Course Contents
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MACRO-ECONOMICS
The course contents consist of national income, consumption, saving

and investment, multiplier, accelerator and aggregate level of
employment, inflation and deflation, international financial institutions,
international economic institutions, monetary policy, fiscal policy,
unemployment, demand and supply of money, financial institutions, and
balance of trade and balance of payments.
Course Aims
The aims of this course are to expose you to macro-economics, the
importance of determination of national income, the interplay of
consumption, saving and investment in the economy, and to understand
the effect of interplay of multiplier and accelerator on the aggregate
level of employment in the economy, the policy instruments normally
employed to control money demand and supply in the economy,
problem of inflation and ways to combat it, and to have a good grasp of
the role of international economic and financial institutions in economic
growth and development of economies. Also the role of GATT and
UNCTAD in world trade, the role of the financial institutions in national
economies, and the problems associated in balance of payments and
appropriate ways to ameliorate them are discussed.
The aims will be achieved by:
1)
2)
3)
4)
5)
6)
7)
8)
9)
explaining the meaning of national income;

explaining the importance of the determination of national
income;
describing the various instruments of monetary and fiscal policy;
explaining the concepts of inflation, deflation and stagflation;
identifying and explaining the various ways to enhance the
workings of multiplier and accelerator in the economy;
describing the role of international economic and financial
institutions;
explaining the role of financial institutions;
highlighting the problems inherent in unemployment and how
unemployment can be tackled; and
discussing the causes of balance of payments disequilibrium and
how they can be ameliorated.
Course Objectives
At the end of the course, you should be able to:
i.
ii.
iii.
iv.
explain the meaning of national income;

discuss the importance of national income determination;
explain the various instruments of monetary and fiscal policy;
describe the concepts of inflation, deflation and stagflation;
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v.
vi.
vii.
viii.
ix.
x.
xi.
MACRO-ECONOMICS
explain the importance of financial institutions to any economy;

describe the role of international economic and financial
institutions;
explain the concepts and principles of multiplier and accelerator;
describe the interrelationship between consumption, saving and
investment;
describe the problem of unemployment and how it can be
tackled;
explain demand for and supply of money;
describe the causes of balance of payments disequilibrium and
how they can be ameliorated.
Course Materials
(2)
(3)
(4)
(5)
Course Guide
Study Units
Text books
Assignment Guide
Study Units
There are 15 units in this course which should be studied carefully. The
units are listed below:
Module 1
Unit 1
Unit 2
Unit 3
Unit 4
Unit 5
National Income
Determination of National Income
Circular Flow of Income
Significance and Limitations of National Income
Consumption, Saving and Investment
Module 2
Unit 1
Unit 2
Unit 3
Unit 4
Unit 5
Multiplier, Accelerator and Aggregate

Employment
Inflation and Deflation
International Financial Institutions
International Economic Institutions
Monetary Policy
Module 3
Unit 1
Unit 2
Unit 3
Unit 4
Unit 5
vi
Fiscal Policy
Unemployment
Demand and Supply of Money
Financial Institutions
Balance of Trade and Balance of Payments
Level
of
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MACRO-ECONOMICS
Each study unit includes an introduction, the objectives of the unit; the
main contents, exercises, conclusions, summary, references and tutormarked questions. It will take at least two hours to finish. You are
expected to study the materials, reflect upon them and attempt the
exercises. There are also reference materials, e.g. textbooks, for further
reading. They are to give you additional information. Practice the selfassessment and tutor-marked questions for greater understanding of the
course. By so doing the stated learning objectives will be achieved.
The Modules
The course is divided into 4 modules. The first three modules have 4
units each while the last have 3 units.
The first module treats national income, determination of national
income, circular flow of income, and significance and limitations of
national income
The second module discusses consumption, saving and investment,
multiplier, accelerator and aggregate level of employment, inflation and
deflation, and international financial institutions.
The third module treats international economic institutions, monetary
policy, fiscal policy, and unemployment
The fourth and last module treats demand and supply of money,
financial institutions, and balance of trade and balance of payments
Assignments
There will be tutor-marked assignments and you are expected to attempt
all of them.
Tutor-Marked Assignment
In doing the tutor-marked assignments, you are expected to apply what
you have learnt in the contents of the study units. After you attempt
them, submit them to your tutor for grading. They constitute 40% of the
total score.
Final Examination and Grading

At the end of the course, you will write the final examination. It makes
up the remaining 60% for the total mark of 100%.
vii
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MACRO-ECONOMICS
Summary
ENT 108 introduces you to national income, multiplier and accelerator
principles, monetary and fiscal policy, demand and supply of money,
unemployment, financial institutions, inflation, deflation and stagflation,
international economic and financial institutions, as well as balance of
trade and balance of payments, among other macroeconomics topics. On
the successful completion of the course, you would have been armed
with the principles and concepts of macroeconomics, which you need
for a better awareness of the workings of the overall economy.
viii
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MACRO-ECONOMICS
Course Code
ENT 108
Course Title
Macro-economics
Course Developer/Writer
Abdullahi S. Araga
Programme Leader
Dr. O. J. Onwe
Course Coordinator
Mrs. E. A. Adegbola

ix
ENT 108

Headquarters
14/16 Ahmadu Bello Way
Victoria Island
Lagos
Abuja Office
No. 5 Dar es Salaam Street
Off Aminu Kano Crescent
Wuse II, Abuja
Nigeria
e-mail: centralinfo@nou.edu.ng
URL: www.nou.edu.ng
Published by

Printed 2009
ISBN: 978-058-391-2
All Rights Reserved
MACRO-ECONOMICS
ENT 108
MACRO-ECONOMICS
CONTENTS
PAGE
Module 1
..
Unit 1
Unit 2
Unit 3
Unit 4
Unit 5
National Income.
Determination of National Income.
Circular Flow of Income........
Consumption, Saving and Investment....
1
6
12
18
24
Module 2
...
34
Unit 1
Unit 2
Unit 3
Unit 4
Unit 5
Multiplier, Accelerator and Aggregate Level of

Employment...
Inflation and Deflation...
International Economic Institutions...
Monetary Policy...
34
41
59
77
86
Module 3
..
94
Unit 1
Unit 2
Unit 3
Unit 4
Unit 5
Fiscal Policy.....
Unemployment.....
Demand and Supply of Money....
Financial Institutions....
Balance of Trade and Balance of Payments.....
94
100
107
117
129
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MACRO-ECONOMICS
MODULE 1
Unit 1
Unit 2
Unit 3
Unit 4
Unit 5
National Income
Determination of National Income
Consumption, Saving and Investment
UNIT1
NATIONAL INCOME
CONTENTS
1.0
2.0
3.0
4.0
5.0
6.0
7.0
Introduction
Objectives
Main Content
3.1
Meaning of National Income
3.2
Concepts of National Income
3.3
Accounting Relationships in National Income
3.4
The Significance of National Income Analysis
Conclusion
Summary
References/Further Readings
1.0
INTRODUCTION
National income relates to the measure of the total value of goods and
services produced in an economy over a period of one year. National
income from all intents and purposes, serves to explain the performance
of an economy. Therefore, it indicates whether the economy is growing
or otherwise, it also reflects the performance of the business
organizations in the economy, which serves as the agents for the
production of goods and services.
2.0
OBJECTIVES
At the end of this unit, you should be able to:
explain the meaning of national income

identify and explain the concepts of national income
mention the accounting relationships in national income.
ENT 108
3.0
MAIN CONTENT
3.1
Meaning of National Income
MACRO-ECONOMICS
National income is regarded as the market value of all goods and

services produced in an economy during a particular period of time,
usually a year. According to Alfred Marshall, national income is the
aggregate net products of and the sole source of payment for all the
agents of production. Sir John Hicks explained that national income is
made up of a collection of goods and services produced on a common
basis which is measured in terms of money.
From the above definitions, it is appropriate to say that national income
is the money value of the end result of all economic activities of a
nation. Economic activities in any country result into a large number of
goods and services, and make a net addition to the national stock of
capital. Such goods and services constitute the national income of a
closed economy. The closed economy is an economy which has no
economic transaction with the rest of the world.
National income in open economy includes also the net results of a
nations transactions with the rest of the world (i.e., exports less
imports). Alternatively, national income is called national product.
Incomes are generated from the production of goods and services. This
value of products represents incomes to households in form of wages,
salaries, rent, interest, or profits. Thus, the total of all incomes must be
exactly equal to the value of all goods and services produced in an
economy within a particular year.
SELF ASSESSMENT EXERCISE 1
Explain the term national income.
3.2
Concepts of National Income
1.
Gross National Product (GNP)
The gross national product (GNP) refers to the value of all goods and
services produced during a specific period of time, usually one year,
plus the difference between foreign receipts and payments. The GNP is,
therefore, identical to the concept of gross national income (GNI);
hence, GNP =GNI. Thus, while the GNP is estimated on the basis of
product flows, the GNI is estimated on the basis of money income
flows, i.e. wages, profits, rent, interest, etc.
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2.
MACRO-ECONOMICS
Gross Domestic Product (GDP)
It refers to the value of total output of goods actually produced in the

whole economy over a period of time, usually one year. It is the gross
because allowance has not been made for the consumption of fixed
capital used up in the production. When the value of the production is
measured at the market price, we have what is commonly referred to as
gross domestic product cost; it is regarded as gross domestic product at
factor cost. The difference between the two lies in the fact that GDP as
factor cost excludes the excess of indirect taxes over subsides that may
have been levied on the goods and services, while the other does not.
3.
Net National Product (NNP)
This is regarded as national income proper. It refers to the sum of all

incomes accruing to all factors of production that are supplied by the
residents of a given country over a period of time, usually a year, after
deducting depreciation. Depreciation herein refers to the value of wear
and tear of capital and machinery replacement after the year of use.
Therefore,
GNP Depreciation = NNP.
NNP = GNP Depreciation.
Depreciation is, in essence, that part of total productive assets which are
used to replace worn-out capital in the process of creating the GNP.
Hence, in the process of producing goods and services (including capital
goods), a part stock of capital is used up. Depreciation is therefore the
term used to denote the worn-out or used up capital. An estimated value
of depreciation is deducted from the GNP to arrive at the NNP.
The NNP is then the measure of net output available for consumption by
the society. The NNP is usually the same as the national income at
factor cost. The NNP is the usually measured at market prices, while
direct taxes and indirect taxes are deducted. Hence, NNP indirect taxes
= national income.
4.
Personal Income
Personal income is the total national income of a particular country or

total GNP less payment of indirect taxes, less undistributed profits, less
profits of public parastatals plus transfer payments (i.e. by government
and business organizations), such as social security allowance,
unemployment benefits, etc. Personal income refers to the income
accruing to individuals, which can be used for paying taxes,
consumption and savings. It constitutes the rewards earned by
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MACRO-ECONOMICS
individuals due to their contribution to the productive sector of the

economy.
5.
Disposable Income
This refers to the income from all sources that accrue to households and
private non-profit institutions after deducting direct taxes and other
transfers. In essence, disposable income constitutes that amount which
an individual can use for the purchase of goods and services and also for
savings. In a frugal economy it is regarded as: Y=C+S.
Identify and explain the various concepts associated with national
income
3.3
Accounting Relationships in National Income
1.
Relations at Market Price

GNP = GNI (gross national income)
GDP = GNP less net income from abroad
NNP = GNP less depreciation
NDP (Net Domestic Product) =NNP less net income from abroad
2.
Relations at Factor Cost

GNP at factor cost = GNP at market price less net indirect taxes
NNP at factor cost = NNP at market price less net indirect taxes
NDP at factor cost = NNP at market price less net indirect taxes
NDP at factor cost = GDP at market price less depreciation
3.4
The Significance of National Income Analysis
(1)
It reflects the extent to which goods and services are valued in

monetary term in any given economy.
National income measures the entire value of goods and services
produced in an economy over a particular period of time (usually
a year). This can be appreciated from GDP, GNP or NNP
analysis, as highlighted above.
National income explains the performance of business
organizations which constitute the unit that produces goods and
services in any economy.
It enables the business organization to appreciate their
contribution to the different sectors of the economy.
(6)
(7)
(8)
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(9)
(10)
(11)
MACRO-ECONOMICS
The GDP explains the overall contribution of the various

businesses and individuals; either the citizens or foreigners.
It also shows the extent to which foreigners participation is
relevant to the national economy.
It enables businesses to adopt better resources allocation and
adjustment procedures as it highlights the individuals
contributions of different sectors of the national economy.

Mention the reasons for the determination of national income.
4.0
CONCLUSION
From the foregoing analysis, you can understand the meaning and
essence of national income. You can also appreciate the reasons which
inform the determination of national income, and the role it plays in the
economy and business operations in any country.
5.0
SUMMARY
This study unit has discussed the meaning of national income. It also
discussed the various concepts associated with national income and the
accounting relationships among such concepts. Lastly, the unit also
discussed the need for the determination of national income.
The next study unit discusses the three approaches used to measure the
value of national income.
6.0
TUTOR-MARKED ASSIGNMENT
1.
2.
Identify and discuss the various concepts associated with national

income.
Mention the merits of the determination of national income.
7.0
REFERENCES/FURTHER READINGS
Begg, D., S. Fischer and R. Dornbusch (2000). Economics, Sixth

Edition. England: .Maindenhead Berkshire.
Lipsey, R.G. and K.A. Crystal (1997). An Introduction to Positive
Economics, Oxford: Oxford Press.
Lipsey, R.G. et al (1987). Economics. New Delhi: Vikas Publishing
House Pvt Limited.
ENT 108
UNIT 2
MACRO-ECONOMICS
DETERMINATION OF NATIONAL INCOME
CONTENTS
1.0
2.0
3.0
4.0
5.0
6.0
7.0
Introduction
Objectives
Main Content
3.1
Income Approach
3.2
Outcome Approach
3.3
Expenditure approach
Conclusion
Summary
1.0
INTRODUCTION
In the preceding unit, you have been introduced to the meaning,

concepts and accounting relationships of national income. This unit
exposes you to the different approaches to the measurement of the
national income, and by extension the difficulties involved in such
methods of determining the national income.
2.0
OBJECTIVES
mention and explain the three approaches for measuring national

income
identify and discuss limitations of the methods used for
measuring national income.
3.0
MAIN CONTENT
3.1
Income Approach
National income is measured through the income approach by adding up

all the incomes earned by the factors of production during the course of
a year. In essence, it is the sum of all incomes received by households
for their services to production. Such incomes include all wages,
salaries, incomes earned by professionals, farmers, and armed forces and
paramilitary personnel as well as all undistributed business profits and
incomes earned by the countrys citizens from abroad.
From the totality of the various incomes, deductions are made for
payments to expatriates from the economy and all transfer payments on
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MACRO-ECONOMICS
the national debts and to individuals. Therefore, national income can be

regarded as the summation of the reward accrued to the factors of
production (land, labour, capital, and entrepreneur) as a result of their
contribution to the production of goods and services.
In summary, the income approach is the summation of the entire income
accrued to the factors of production, due to their contribution to the
economy, i.e. the summation of wages, interest, profit and rent.
The shortcomings involved in this method include the following:
1.
Undistributed Incomes
More often, a substantial portion of income generated by business

entities is retained in the business operations; the owners tend to reinvest
what they have realized instead of sharing it as profits among the
shareholders. Using this method to measure national income, therefore,
may be misleading; major part of the profits cannot be calculated and
this represents a shortfall in the level of net national income.
2.
Absence of Rent Payment on Owner-occupier Houses
Houses occupied by their owners do not attract rent payments. This

represents underestimation in national income.
3.
Goods Produced and Consumed by Producers
An underestimation of national income involves some goods and

services that are produced and consumed by the producers themselves
under subsistence sector of the economy. Income from their payments
which are foregone escapes estimation of the national income.
4.
Unpaid Services
There are services which are rendered by some people that are not paid
for. Examples are building of a house by the owner himself, laundry
services rendered by the person himself, free services rendered to
relations, and free services rendered to a persons relations, etc. Income
from their payments which are foregone also escapes estimation of the
national income.
5.
Absence of Definite Remuneration for Self-Employed People
Some individuals who are self-employed do not claim definite wages or

salaries. Self-employed people are those people who are not under the
employment of any organizations or who are not employed by other
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MACRO-ECONOMICS
individuals on wage or salary basis. These types of people do earn

incomes which cannot be classified as a profit or reward to the
entrepreneur or a wage, the reward to labour. Therefore, the procedure
for measuring national income becomes faulty and hence leads to
underestimation.
1.
2.
Explain the income method of national income estimation.

List and explain the problems involved in estimating national
income using income approach.
3.2
Output Approach
This approach to measurement of national income, involves estimating

the national income as the sum total of the market values of all goods
and services produced in the economy, in a given period of time. It is
only the value of the final goods and services that is considered in this
approach to the measurement of national income. This is estimated by
adding subsidies, and subtracting the value of indirect taxes.
In summary, the output approach is concerned with the measurement of
the national income through the summing up of the market value of the
final goods and services produced in an economy over a year.
The inherent shortcomings of the output method include the following:
Risk of Double Counting
This arises due to the interrelationships between and among

commodities whereby some firms outputs constitute the inputs of other
firms. In this situation, there is always a tendency for counting the value
of some commodity more than one time. This is the problem of double
counting.
Omission of Unpaid Services
Some activities, especially services whose value is supposed to be

incorporated, are often neglected in output estimation. For instance, the
value of the services of a housewife which should be taken into
consideration national income estimation is always neglected. Such
form of service commands a value and deserves to be considered in
national income.
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MACRO-ECONOMICS
Self-Service Activities
The identification of some self-service activities is not easily realized.

Therefore, to determine the extent and their level of their value in
monetary terms will not be an easy task. Hence the income method
always leads to underestimation of the actual amount of national
income.
1.
2.
Explain the output method of national income estimation.

income using output approach.
3.3
Expenditure Approach
This method which is also known as the final method, measures national
income at the final expenditure stages in the economy. In essence, the
expenditure approach entails the measurement of the entire spending of
households, firms and government on goods and service.
In estimating the national income using the total national expenditure,
any of the following two methods are employed:
1.
In this first method, all the money expenditure at market price are
computed and added up together. The items of expenditure
which are taken into consideration under this method are:
(a)
(b)
(c)
private consumption expenditure;

direct tax payments; and
payment to non-profit making institutions and charitable
organizations like schools, hospitals, orphanages, etc;
2.
Under this second method, the value of all the products finally
disposed of are computed and added up.
The items of
expenditure which are taken into consideration under this method
are:
(a)
(b)
(c)
(d)
consumer goods and services;

private investment goods;
public goods/services; and
investment abroad.
The second method is more widely used because the requisite data
required by this method can be collected with greater ease and accuracy.
This approach, as portrayed above, involves estimating the sum of all
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MACRO-ECONOMICS
consumption expenditure, investment

expenditure and export expenditure.
expenditure,
government
Shortcomings inherent in the expenditure approach include the

following:
1.
It is technically difficult to isolate intermediate products from the

final products.
2.
It is practically an impossible task to obtain actual factor price of

goods particularly in less developed countries.
In national income accounting, the basic overall aggregate being

measured is the total value of output at factor cost either in constant or at
current market prices. This can be considered in terms of the output (O)
itself or the income (Y) it generates or the expenditure (E) required to
purchase it. However, the details of each calculation give independent
information but the totals do not since the three are defined so that they
are identical. That is:
Total Income = Total Output = Total Expenditure
Y=O=E
1.
2.
Explain the expenditure method of national income estimation.

income using expenditure approach.
4.0
CONCLUSION
You can understand from the foregoing discussion that there are three
approaches that could be used in measuring national income. All of
these approaches have their peculiar shortcomings. The choice of any of
the approaches depends upon the available data for measuring national
income.
5.0
SUMMARY
The unit has discussed national income in terms of the three approaches
(income, output and expenditure methods) that can be used to estimate
it. The inherent limitations of each approach have been identified and
discussed. The next unit discusses the circular flow of income.
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6.0
MACRO-ECONOMICS
Mention and discuss the three approaches used in measuring national

income.
7.0

Economics. Oxford: Oxford Press.
Lipsey, R.G. et al (1987). Economics. London: Harper and Row
Publishers.
Dwivedi, D.N. (1987). Managerial Economics. New Delhi: Vikas
Publishing House Pvt Limited.
11
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UNIT 3
MACRO-ECONOMICS
CIRCULAR FLOW OF INCOME
CONTENTS
1.0
2.0
3.0
4.0
5.0
6.0
7.0
Introduction
Objectives
Main Content
3.1
3.2
Two-Sector Model
3.3
Concepts in National Income Determination
Conclusion
Summary
1.0
INTRODUCTION
The Keyness analytical framework holds that the entire economy can
be divided into four sectors such as household sector, firms or the
business sector, government sector, and foreign sector. However, there
is a simple model which involves a circular flow of income to the twosector model, involving only the household and firms or the business
sectors. In this unit, we shall discuss the circular flow of income
involving some sectors in the economy.
2.0
OBJECTIVES
identify various sectors of a national economy

list and explain the flow of inputs and outputs and income among
the sectors
draw simple diagrams illustrating the circular flow of income.
3.0
MAIN CONTENT
3.1
The circular flow of income is a simple model of the economy showing

flows of goods and services and factors of production between firms and
households. In the absence of government and international trade this
simple model shows that households provide the factors of production
for firms who produce goods and services. In return the factors of
production receive factor payments, such as wages, which in turn are
spent on the output of firms.
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MACRO-ECONOMICS
In reality, households do not spend all their current income. Some of the
income earned by the providers of factors of production is saved. This
represents a leakage from the circular flow. In addition to the consumer
spending, firms also carry out investment spending. This is an injection
to the circular flow of income, as it does not originate from consumers'
current income.
In actual fact, it can be considered two flows, one of goods and services
and a flow of money. The size of these flows is an indicator of the
amount of economic activity. The circular nature of the flows means that
there will be a number of different ways of measuring the size of the
flow. Economists maintain that there are three possible ways of
measuring this flow with each way looking at a different part of the
circular flow of income. All the three methods should give the same
magnitude of the national income.
These methods are as discussed in the preceding unit such as the output
method which shows the total amount of goods and service produced in
one year, the expenditure method shows the total amount of domestic
spending by consumers, firms, government and foreigners, and the
income method shows the total incomes earned by the factors of
production involved in the production of goods and services in one year.
In this unit we shall deal with the various aspects, of the theory of
income determination, including the circular flow income, and the
theory of the multiplier.
Explain the term circular flow of income.
3.2
Two-Sector Model
In this two-sector model, the economy is closed with no government and

foreign sectors. The model assumes:
There are only two-sectors-households and firms.

Households are the owners, and firms are the users of those
factors of production.
Household incomes comprise factors payments-wages, interest,
rent and profits. Households spend their total income on
consumer and capital goods.
The economy is spendthrift, with no element of savings
There is no foreign trade and no government expenditure.
13
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MACRO-ECONOMICS
The circular flow of income shows how income flows from firms to
households and how expenditure flows households to firms. It portrays
in very simple terms how the economy works. The circular flow of
income is very useful in the theory of income determination, for it
shows that, if withdrawals from the flow are equal to injections into
the flow, then national income will remain at the same level.
Withdrawals are as result of savings, taxation and expenditure and
imported goods. Injections are due to investment and government
expenditures and income form exports.
Figure 3.1 below shows the two-sector model of a circular flow of
national income. It involves a simple model showing only households
and firms sectors.
Fig 3.1: Two-Sector Model of Circular Flow of National Income.

In the real world, the government and international trade sectors must
also be included. Economic systems are in reality three sector open
economies. Consequently, there will be additional leakages and
injections. Government spending will be injected into the circular flow
and taxation will leak from it. Export flows will be injected and imports
14
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MACRO-ECONOMICS
flows leaked. A full circular flow with leakages and injections is shown
below.
Fig 3.2: A Circle Flow of National Income

The Figure (3.2) above shows a circular flow of national income in an
open economy, which shows a flow of income in an open economy. The
above model of the economy demonstrates that economic activity is a
flow involving many sectors.
The figure is divided into two parts. The upper half represents the factor
market in which households sell and firms buy the services or factors of
production. In the process, income factors, i.e. wages, interest, rent and
profit move from the firm and flow to the household.
The lower part of the figure represents the product or commodity market
where firms sell and households buy the commodities. In this process,
household incomes flow to the firms and commodities flow to the
household. From the diagram, therefore, payments flow firms to
household in the form of payments for the factors of production; and
from households back again to forms in the form of expenditure on
goods and services within the economy.
15
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MACRO-ECONOMICS

Explain the circular flow of income in an open economy.
3.3
Concepts in National Income Determination
The various concepts involved in the theory of income determination are

as discussed below.
1.
Withdrawals
Withdrawals are incomes received in the course of the circular flow but
which are not passed on in the flow. It is called withdrawals because it is
the payment received from the flow but kept out of it. Examples are
savings and undistributed profits of firms. Withdrawals have a
contractionary effect on the national income.
2.
Injections
An injection is income passed into the circular flow of income from

outside the system. A good example is investments by firms. Injections
have an expansionary effect on the national income.
3.
Consumption
Consumption is that part of income which is spent on goods and services

that are used up with a specified time, usually a short period.
4.
Saving
Saving is that part of income which is neither spent on goods and

services for current consumption, nor invested.
5.
Investment
An investment is that part of income which is spent on real capital

goods. That is, it is payment on physical productive assets, i.e. goods
which are not meant for immediate consumption, e.g. factory buildings
and road construction machinery.
List and explain the concepts of national income determination.
4.0
CONCLUSION
From the discussion above, you can appreciate the nature of circular
flow of income. There two-sector model of circular flow of income
16
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MACRO-ECONOMICS
clearly informs us as to how a simple economy works. The implication

of the model for the open economy is that there are many variables at
play in such an economy.
5.0
SUMMARY
This unit has been used to discuss the circular flow of national income.
It has also discussed the two-sector model, which obtains in a simple
economy. Furthermore, the type of circular flow of income that obtains
in an open economy has been discussed in the unit. Lastly, various
concepts related to it such as consumption, saving, investment, are also
discussed. The next study discusses the significance and limitations of
national income estimates.
6.0
Mention and explain the concepts associated with national income

determination.
7.0

Publishers.
Publishing House Pvt. Limited.
17
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UNIT 4
MACRO-ECONOMICS
SIGNIFICANCE AND LIMITATIONS OF

NATIONAL INCOME
CONTENTS
1.0
2.0
3.0
4.0
5.0
6.0
7.0
Introduction
Objectives
Main Content
3.1
Significance of National Income Estimates
3.2
Problems Inherent in National Income Estimates
3.3
Limitations of National Income Estimates
Conclusion
Summary
1.0
INTRODUCTION
In the previous units, we have discussed extensively the nature of

national income. The areas considered include the meaning of national
income, the accounting relationships in national income, the methods
involved in the measurement of national income and the circular flow of
national income.
In this study unit, the importance and limitations of national income
statistics will be discussed. In essence, you will be exposed to the
understanding of the significance of the measurement of national
income as well as the inherent limitations in the estimation of national
income.
2.0
OBJECTIVES
discuss the significance of national income statistics

identify and explain the inherent problems in national income
estimation.
3.0
MAIN CONTENT
3.1
Significance of National Income Estimates
The estimate of the national income is useful in the following ways

1.
18
The gross national product indicates the overall economic

performance of a country. It tells whether the national out put is
growing or declining. This is because an increase in the national
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MACRO-ECONOMICS
income represents increased national output. Since the national

income is a measure of the value of total national output, an
increase represents growth in the national product.
2.
National income estimates help us to know the contribution made

by each sector of the economy to national output. Since the
national income is a representation of sectoral contributions, an
analysis of the various contributions of different sectors of the
economy is presented. This provides a basis for understanding the
different sectoral contributions, and helps determine the rate at
which each sector is growing or declining.
3.
National income figures indicate the standard of living through

showing the per capita income (PC) where PCI = GNP
population. This measure, i.e., the per capita income explains the
income per person, and the income per person indicates the
standard of living of the people in a country. The higher the per
capita income, the higher the standard of living and vice versa. If
the national income of a country seen through the GNP increases,
then with a constant population size, the standard of living of the
country is expected to rise and vice versa.
4.
It is used to compare the standard of living in different countries

through the use of per capita income. The standard of living of
different will enable a country to assess its performance in
relation to other countries of the world, a particular country could
determine the steps it could take to raise the standard living of
citizens to match that of other nations citizens.
5.
National income statistics are used in determining how much a

country should contribute to international organizations, e.g., the
United Nations, I.M.F, World Bank, African Union (AU), etc.
These agencies are specialized international bodies that perform
different tasks and activities which are of global benefit and,
naturally, being organizations charged with particular
responsibilities, they need to be sponsored through different
ways. The extent to which a particular country can contribute
often depends on the level of her resources.

What are the uses of national income determination?
3.2
Problems Inherent in National Income Estimates
The general problems of measuring the national income irrespective of

the approach used can be explained under the following points:
19
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1.
MACRO-ECONOMICS
The Danger of Double Counting
This is in the areas of transfer payments, prices of intermediate goods,

etc. you may want to ask what constitutes transfer payments and prices
of intermediate goods. Transfer payments refer to the payments on
income received by an individual which is not a reward for his own
labour, e.g. bonuses, and charity. All these should be excluded from the
overall national income estimate.
In the same consideration, the prices of intermediate goods, which are
semi-finished goods, should be excluded. They are regarded as
intermediate or semi-finished because they may likely be used to
produce other products (final goods), which when considered will
represent double counting of the same commodity (as input and as
output).
2.
Treatment of Depreciation
Depreciation, as seen in the previous unit, refers to wear and tear

valuation. It remains a problem especially with respect to the
expenditure approach, as its inclusion may amount to
over/undervaluation of the real national income figure itself.
3.
Treatment of Illegal Activities
Illegal activities such as prostitution and gambling are not included in

the national income, whereas they are services and generate income.
Since they generate income, such activities ideally are supposed to form
part of national income as they represent earnings. Since they are
considered in society as a taboo, they are not included. This negligence
of these activities may tremendously render national income estimation
insufficient.
4.
Decision on Items to Include
There is the problem of what to include and what to exclude from the
national estimation, for instance, the services of the housewife, which
are economically valuable. Since all economic activities are supposed to
assume value, the negligence of services such as those of the housewife
represents a serious underestimation of the real value of the national
income.
Identify and explain problems inherent in national income estimates.
20
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3.3
MACRO-ECONOMICS
Limitations of National Income Estimates
The estimate of the national income has some limitations. These

problems make its usefulness questionable and even, sometimes,
inadequate particularly when it is used as a measure of the standard of
living for an economy.
1.
The per capita income, which is calculated from the national

income estimate, is only an average. Although it gives the flow of
goods and services per person, it does not tell us how the goods
and services are distributed among the various components of the
economy.
2.
National income estimates fail to tell us the kinds of goods and

services produced. They only tell us the sectoral contribution in
monetary terms.
3.
The national income neglects some important factors which

influence the standard of living. For instance, it does not consider
life expectancy and working conditions. It only measures the
volume of income irrespective of how it is generated.
4.
Many people tend to give false information, thereby making the

data available for national income computation misleading. For
instance, businessmen often refuse to give the real picture of their
business for fear of taxation.
5.
The exchange of service for service is a practical problem facing

national income data collection. For instance, in the rural areas of
Africa communal activities are very common. This is a situation
in which people organize themselves to work as a team for one
another in turns.
6.
The necessary tools to use, e.g. computers, telephones plus other

administrative facilities are often unavailable or grossly
inadequate, thereby impeding the efficiency of the people that
gather information about the goods and services produced in the
economy.
7.
Some exchanges of goods, particularly in less developed

economies, take place on barter basis. So computation on such
goods in monetary terms is not possible. This has to do with
those modes of exchange through trade by barter, whereby people
exchange goods for goods.
21
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MACRO-ECONOMICS
8.
Technical expertise for collecting national income data is

sometimes lacking, especially in the less developed economies.
This problem makes such countries rely on insufficient
manpower to obtain the data.
9.
Some illiterate businessmen and women do not keep accounts of

their business, and that makes it difficult for accurate national
income computation. This is a serious problem since it is through
the summing up of the entire value of the national output that the
national income is arrived at.

What are the limitations inherent in national income estimates?
4.0
CONCLUSION
National income accounting is of strategic importance to a country since

it shows the output generated and the standard of living of the citizens of
the country concerned. In this unit, therefore, you have been exposed to
the significance of national income estimates. You also been exposed to
the fact that the estimates of national income have some inherent
problems and limitations.
5.0
SUMMARY
National income is the income received by the residents of a country in

a given period as payment for services offered to production.
GDP at factor cost is total money value of all goods and services
produced in a country over a period, minus indirect taxes, plus subsidies.
GDP at constant prices is the GDP at market prices, collected for a
series of years, and statistically adjusted to eliminate the influence of
inflation.
GDP at market prices = GDP at market prices depreciation. The
national income can be measured by using the output, income or
expenditure approach, each of which has peculiar problems, although all
the three yield the same result.
The next study unit is used to discuss consumption, savings and
investment.
6.0
Discuss the uses and limitations of national income estimates.

22
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7.0
MACRO-ECONOMICS

Publishers.
23
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UNIT 5
MACRO-ECONOMICS
CONSUMPTION, SAVING AND INVESTMENT
CONTENTS
1.0
2.0
3.0
4.0
5.0
6.0
7.0
Introduction
Objectives
Main Content
3.1
Consumption
3.1.1 Meaning of Consumption
3.1.2 Consumption Function
3.1.3 Consumption Function with Constant
3.1.3 Consumption Function with Constant
3.1.4 Determinants of Consumption
3.2 Saving
3.2.1 Meaning of Saving
3.2.2 Determinant of Saving
3.3 Investment
3.3.1 Meaning of Investment
3.3.2 Determinants of Investment
Conclusion
Summary
1.0
INTRODUCTION
In unit three, you observed that consumption is one of the components

of the national income. It constitutes the largest component of aggregate
expenditure of most countries. Therefore, in order to predict the effects
of shifts in autonomous expenditure on equilibrium national income, we
need to know the relationship between consumption and national
income. And also, in the simple tow-sector model, consumption is the
only expenditure flow that is induced.
Saving arises from the fact that it is not all income generated that is
consumed. The portion of income not consumed is saved, and this gives
rise to the concept of investment. Hence, the three related concepts of
consumption, saving and investment are discussed in this unit.
2.0
OBJECTIVES
At the end of this unit, it is expected that you should be able to:
24
explain consumption and consumption function

define both saving and investment
explain the determinants of savings and investment
ENT 108
MACRO-ECONOMICS
discuss the propensities to save with the help of diagrams

explain the theories of investment
explain the importance of savings and investment to business
firms.
3.0
MAIN CONTENT
3.1
Consumption
3.1.1 Meaning of Consumption

Consumption refers to the act of using goods and services to satisfy
wants. By extension, consumption expenditure is that part of national
income that is spent on purchasing goods and services for consumption
in the economy.
The central proposition of this simple version of national income
analysis is that aggregate real consumption expenditure in the economy
is determined by the level of disposable (after tax) income. Disposable
income, as propounded by John Maynard Keynes, is the propensity to
consume, although nowadays it goes by the less elegant term
consumption function.
Explain the term consumption.
3.1.2 Consumption Function

The consumption function shows the level of aggregate consumption in
the economy given some magnitude of the total income available to the
economic variables such as the households. The diagram below shows
an economy in terms of consumption as against some level of income.
Real disposable income is measured on the horizontal axis. The fortyfive degree line denotes that any point on the line is equidistant from the
two axes. The level of disposable income can, therefore, be measured
vertically as a straight line with a slope of less than one. The slope of the
consumption function, or the marginal propensity to consume,
measures that fraction of each additional disposable income that will be
consumed.
In theoretical terms, and as indeed empirical evidence, the marginal
propensity to consume (MPC) is less than one. Consequently, at each
additional disposable income, the households will increase its
consumption by a fraction and will save the remainder Consumption
25
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MACRO-ECONOMICS
Y=C+S
C = C (c/d)
Income
Fig. 5.1: Consumption Function
Using this simple case in which a constant proportion of income is spent

on consumption, expenditure will be a certain per cent of the total
income. Assuming it is 50 per cent, it means that 50 Naira of the total
income will be spent on consumption. Both the APC and MPC are equal
if the consumption function is a straight line emanating through the
origin.
With appropriate diagram, discuss consumption function.
3.1.3
Consumption Function with Constant
Consumption functions are measured on the basis of annual data.

Aggregate consumption and aggregate household income tend to fit the
data appropriately if they contain a constant. The constant introduced
changes the equation of the consumption function to become thus:
C = a+cy
From above: C = consumption; a = autonomous consumption; cy =
consumption arising from income.
26
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MACRO-ECONOMICS
Consumption
Yo
Y1
Income
Fig. 5.2: Consumption Function with a Constant

Figure 5.2 shows a consumption function with an intercept of a and
slope of C. when income goes from Yo to Y1,
MPC is c
Y
It means, mathematically, that C is the slope of the line, and
economically, it refers to extent of the change in consumption with
respect to a change in income. According to Keynes, it is called
marginal propensity to consume (MPC). It shows what proportion of a
change in income will be consumed. Thus:
c {dc} = MPC
Y {dy)
Keynes posited that the MPC should be positive, but less than 1, which
means that some portion of additional income will be spent, not all of it,
and it follows that consumption cannot be unaffected by a change in
income.
Since we have assumed a linear relationship, it means that MPC is
constant (the slope of the straight line is always a constant), and thus
assumed that whatever the level of income of the households, any
change from the level will be divided up into consumption and saving in
the same fixed proportions.
Furthermore, the marginal propensity to consume (MPC) relates to
changes in consumption induced by changes in income. In order to
27
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MACRO-ECONOMICS
discover what proportion of a given of income is devoted to

consumption, another concept called the average propensity to consume
(APC) is needed. The average propensity to consume can be written as
C/Y.
With appropriate diagram, discuss consumption function with
autonomous constant.
3.1.4 Determinants of Consumption

There are many variables or factors that exert strong influence on
consumption. These factors include:
1.
Change in Income Distribution
If the income is skewed towards the rich, there will be more

consumption of luxury goods, such as cars, jets, etc. while if the
distribution of income is skewed towards the poor, then there will be
more consumption of necessity goods such as food and clothes.
2.
Changes in Terms of Credit
Anything that changes the cost and availability of credit temporarily,

shift the consumption function and thus affect aggregate demand.
3.
Changes in Existing Stock of Durable Goods
These changes are more volatile and can cause a sharp shift in the
consumption function.
4.
Changes in Wealth
If wealth comes unexpectedly, households will increase their savings

and vice versa.
5.
Changes in Price Level
As prices of commodities increase (as commodities are more

expensive), consumption reduces and vice versa.
Identify and explain the various factors that influence consumption.
28
ENT 108
3.2
MACRO-ECONOMICS
Savings
3.2.1 Meaning of Savings

Savings is defined as that part of all disposable income that is not
consumed. Saving arises from the fact that it is not all incomes
generated that is consumed. The portion of the total income in the
economy that is not consumed normally goes into savings.
Basically, households in the economy decide how much to consume and
how much to save. The households take the decision on how to divide
their disposable income between consumption and saving. It follows
that, once we can determine the dependence of consumption on
disposable income, we can also know the dependence of saving on
disposable income.
Two saving concepts are exactly parallel to the consumption concepts of
APC and MPC. The average propensity to save, APS is the proportion
of disposable income that households want to save. It is derived from
diving total desired saving by total disposable income:
APC = DS/DYd.
The marginal propensity to save is the change in saving as a result of
change in disposable income of the households.
Since income is either spent or saved, it follows that the fractions of
income consumed and saved must account for all income; that is,
APC + APS = 1.
It also follows that the fraction of any increment to income consumed
and saved must account for the increment. That is,
(MPC + MPS) = 1
Assuming MPC is 4/5 the MPS must be 1/5; the two together making 1.
Discuss saving in relation to APC, APS, MPS, and MPC.
3.2.2 Determinant of Savings

There are many variables or factors that exert strong influence on
savings. These factors include:
29
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1.
MACRO-ECONOMICS
Size of Income
Income is the major determinant of savings. The higher the income, the
more one saves and vice versa. This is the more reason why high income
earners save more than low income earners.
2.
Rate of Interest
Classical economists consider that in order to induce people to forgo the

present for future enjoyment, compensation in the form of interest has to
be paid. The higher the rate of interest, the more people would save.
3.
Psychological Attitudes
Some societies are by nature more thrifty than others, providing against
sickness, unemployment, old age, and for education of dependants.
Certain people save beyond these needs; either it gives them a feeling of
power, independence or security or because they want to leave
something to an heir.
4.
Social Environment
Besides influencing the general attitude to saving, the environment can

be a major factor in other ways. In an urban area example, there are a lot
of banks, saving institutions, etc. such institutions usually campaign and
advertise their products extensively. In rural areas, saving is very low
because banks and saving institutions are not very much available.
5.
Government Policy
The government can influence peoples saving in a variety of ways.

Some countries have compulsory saving schemes where people,
especially workers, are forced to keep some portion of their income for
the rainy day. In some other countries, the government tries to stimulate
personal savings through the rate of interest, propaganda, income tax
concessions as well as other special devices like savings certificates and
premium bonds.
Identify and explain the various factors that influence savings.
30
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3.3
MACRO-ECONOMICS
Investment
3.3.1 Meaning of Investment

Investment is regarded as the expenses made on the production of goods
for future consumption. It simply involves the act of producing goods
that are not for immediate consumption; such as capital goods, inventory
and residential housing. Investment expenditure, therefore, means
expenditure on capital goods.
Investment expenditure is also a component of the national income,
which has to be considered when determining the equilibrium national
income. It has a short run and long run effect on the national income. In
the short run, the important effect of investment is on aggregate
expenditure, and by implication, on the degree to which existing
recourses are employed.
By extension, it has an influence on the national income in the economy.
In the long run, the decisive effect of investment on national income is
through its effects on the capital stock, and hence, on the size of
potential growth of the national income.
Explain the term investment.
3.3.2 Determinants of Investment

There are a number of factors that determine the level of investment in
any economy. The most important ones among them are:
1.
The Price and Productivity of Capital Goods
Cheap capital goods with high productivity will result in a high rate of
investment and vice versa.
2.
Business Expectations
These are the attitudes, beliefs or states of mind of people about the
nature of economic events. Expectations are often crucial in determining
economic behaviour. A firm or an investor may select a price level of
output or investment alternative based on what the future of economic
events is anticipated to be.
31
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3.
MACRO-ECONOMICS
Development of New Techniques and New Products
The higher and the more sophisticated the techniques of production are
the more the level of investment and vice versa.
4.
Availability of Profits for Re-Investment
When the net profit is high, there is the possibility or re-investment by

investors; but when the net profit is low, the level of re-investment by
investors may be low.
5.
Government Policy
Fiscal policies such as taxation, ranging from personal income tax and
profit tax, to tariffs, shape the direction of investment. So also does the
monetary policy such as preferential credit scheme, liquidity ratio, etc.
6.
Level of National Income
It is expected that the higher the level of national income, the higher will
be the level of investment in the economy.
7.
Rate of Interest
The lower the rate of interest, the greater the number of investment
opportunities that would be profitable and, therefore, the greater the
investment expenditure firms wish to make, and vice versa. Let us
dwell for a moment on investment by firms, which constitutes the
largest single source of investment expenditure.
8.
Level of Profits
Profits constitute the basic motive to the investment decisions of private

sector firms. Firms spend money on new investment where they expect
the investment to yield reasonable of profits over the cost of investment.
The forces that affect these expectations determine the amount of
desired investment expenditure in the economy as a whole. Such factors
include the following:
a)
b)
c)
d)
32
The price and productivity of capital goods.

Expectations about the future demand for the output of capital
goods and about the cost of producing those goods.
The development of new techniques of production and of new
products.
Profits earned by firms and which are available for re-investment.
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e)
MACRO-ECONOMICS
The rate of interest, the lower the rate of interest, the greater the
number of investment opportunities that would be profitable and,
therefore, the greater the investment expenditure firms would
wish to make.

Identify and explain the determinants of investment.
4.0
CONCLUSION
From the foregoing discussion, you have observed that aggregate level
of consumption has the potential effect of causing shifts in autonomous
expenditure on equilibrium national income in the economy. You also
understand that in a simple two-sector model, consumption is the only
expenditure flow that is induced. The discussion also points out that
saving arises from the fact that it is not all income generated that is
consumed. The portion of income not consumed is saved, and this gives
rise to the concept of investment.
5.0
SUMMARY
In this unit, three related macroeconomic variables of consumption,

saving and investment have been discussed. Also, the meaning of
consumption, consumption function and determinants of consumption
have been discussed. In addition, the meaning and determinants of
saving are also discussed. Lastly, the meaning and determinants of
investment are explained.
The next study unit discusses multiplier, accelerator and aggregate level
of employment
6.0
1.
2.
Differentiate between consumption, saving and investment.

Identify and explain the determinants of consumption and
investment.
7.0

Publishers.
33
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MACRO-ECONOMICS
MODULE 2
Unit 1
Multiplier, Accelerator and Aggregate

Employment
Inflation and Deflation
International Economic Institutions
Monetary Policy
Unit 2
Unit 3
Unit 4
Unit 5
UNIT 1
Level
of
MULTIPLIER, ACCELERATOR AND

AGGREGATE LEVEL OF EMPLOYMENT
CONTENTS
1.0
2.0
3.0
4.0
5.0
6.0
7.0
Introduction
Objectives
Main Content
3.1
Multiplier Principle
3.1.1 Multiplier Effect
3.1.2 Factors Affecting Size of Multiplier
3.2
Accelerator Principle
3.2.1 Accelerator Effect
3.2.2 Limitations of the Accelerator Principle
Conclusion
Summary
1.0
INTRODUCTION
In the preceding unit, you have been exposed to the discussion on

consumption, saving and investment as they affect the economy in a
given country. Multiplier and accelerator are also macroeconomic
variables that also affect the operations of the economy in any country.
The concept of the multiplier assumed a front burner in the 1930s when
John Maynard Keynes, the eminent economist, posited that it should be
employed as a tool to help governments to achieve full employment.
The multiplier per se arises as a result of change in the aggregate
income, consumption and investment in the economy. A related
macroeconomic variable is the accelerator theory which relates
investment to change in aggregate income and by extension, a change in
aggregate demand in the economy. Hence, the multiplier process and the
accelerator theory are the subjects of discussion in this unit.
34
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2.0
MACRO-ECONOMICS
OBJECTIVES
explain the multiplier effect

identify and discuss factors affecting size of multiplier
discuss the accelerator principle
identify and explain limitations to accelerator principle.
3.1
Multiplier Principle
3.1.1 Multiplier Effect

The multiplier as an economic tool is regarded as macroeconomic
demand-management approachwhich measures the amount of
government spending needed to reach a level of national income that
would prevent unemployment in the economy.
The higher is the propensity to consume domestically produced goods
and services, the higher is the multiplier effect. An initial change in
aggregate demand can have a much greater final impact on the level of
equilibrium national income. This is commonly known as the multiplier
effect. It comes about because injections of demand into the circular
flow of income stimulate further rounds of spending. In other words,
one consumers spending becomes anothers income. This leads to a
much bigger effect on equilibrium output and the aggregate level of
employment in the economy.
For instance, an investment of N300 million in business capital is
capable of creating a new production plant in the country. This will set
off a chain reaction of increases in expenditures. Firms that produce the
capital goods that are purchased will experience an increase I their
incomes and profits. Assuming they in turn, collectively spend about
three fifth of that income, then N180 million will be added to the
incomes of others.
Hence at this stage, total income has grown by N300 million + (0.6 x
N300 million), thus giving the total of N480 million. The sum will
continue as the producers of additional goods and services realize an
increase in their incomes, of which they in turn spend 60% on even
more goods and services.
The increase in total income will be N300 million + (0.6 x N300
million) + (0.6 x N180 million), which amounts to N588 million. The
increase in the total income will continue indefinitely. Nevertheless, the
35
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MACRO-ECONOMICS
additional rise in spending and income is a fraction of the previous

addition to the circular flow.
Fundamentally, therefore, multiplier effects can be seen when new
investment and jobs attracted into a particular town, city or region of a
country. The increase in output and employment can be far greater than
the initial injection of demand because of the interrelationships within
the circular flow of income.
The overall effect is that the aggregate level of employment in the
economy will be affected positively since more jobs are bound to be
created as a result of the increase in the level of investment in the
economy. In essence, more jobs will be created from the new investment
occasioned by the increase in the aggregate demand for goods and
services, which arises from the increase in aggregate income in the
economy.
Explain the multiplier effect in the economy.
3.1.2 Factors Affecting Size of Multiplier

The government can influence the size of the multiplier through changes
in direct taxes. For instance, a cut in the basic rate of income tax will
increase the amount of extra income that can be spent on further goods
and services.
Another factor affecting the size of the multiplier affect is the prosperity
to purchase imported goods. For instance, if out of extra income people
spend money on imported goods; this demand is not passed on in the
form of extra spending on domestically output. It leaks away from the
circular of income and spending.
The multiplier process also requires that there is sufficient spare
productive capacity in the economy for extra output to be produced. If
short-run aggregate supply is inelastic, the full multiplier effect is
unlikely to occur, because increases in aggregate demand will lead to
higher prices rather than a full increase in real national output. In
contrast, when short-run aggregate supply is perfectly elastic a rise in
aggregate demand causes a large increase in national output.
Empirical evidence has shown that the construction sector of the
economy as a result of its multiplier effect is capable of dividing a
tremendous magnitude of economic growth and job creation. In essence,
36
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MACRO-ECONOMICS
there is compelling evidence on the multiplier effects of major capital

investment projects in various economies around the world.
A major characteristic of the construction activity is the fact that it feeds
through to many other related businesses. Fundamentally, construction
operation has an awkward linkages into the likes of building materials
such as steel, architectural services, legal services and insurance.
Most of the construction linkages tend to result in jobs. This makes a
boom in construction peculiarly powerful in fuelling expansion in the
economy. For example, for a given rise in building orders, the multiplier
effect may be well over two. The implication is that every building job
created will generate at least two others in related areas and in
downstream activities such as retailing, which benefits when building
workers spend their wages. Other industries particularly those where
much of the output value comes in the form of imported components,
might have a less multiplier effects arising from the new projects.
Identify and discuss factors affecting the size of multiplier.
3.2
Accelerator Principle
3.2.1 Accelerator Effect

The accelerator principle holds that a planned capital investment by
private sector businesses is usually linked to the growth demand for
goods and services in the economy. For instance, when consumer
demand is rising strongly, businesses may increase investment to expand
their production capacity and meet extra demand. This is the accelerator
effect.
The accelerator effect in the form of increase in capital investment and
expansion in production capacity has overall effect of creating more jobs
in the economy. In essence, more jobs will be created from the new
investment in production operations of the private sector companies.
Fundamentally, therefore, the accelerator principle is also a demandmanagement macroeconomic variable which is used to explain the
relationship between investment and change in demand arising from a
change in income of the consumers. The increase in aggregate demand
for goods and services occasioned by an increase in the aggregate
income of the consumers usually triggers off change in investment
towards coping with the resultant increase in demand for goods and
services.
37
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MACRO-ECONOMICS
According to the theory, therefore, investment is related to change in

national income which results in change for more goods and services.
Hence when national income is increasing it is necessary for businesses
to invest more in production facilities in order to increase their capacity
to produce consumer goods to meet increased consumer demand. This is
aptly illustrated in Fig 6.1.
Fig 6.1. The Accelerator Principle (Consumer Demand and Capital
Stock)
Year Annual sale Change
in sale
1
2
3
4
5
6
7
8
9
10
10
10
11
13
16
19
22
24
25
25
0
0
1
2
3
3
3
2
1
0
Required stock
of capital
K/
Q is 5:1
50
50
55
65
80
95
110
120
125
125
Net investment,
increase in the
required capital
stock
0
0
5
10
15
15
15
10
5
0
As we can see in table 6.1 when change in sales is constant, change in

investment is also constant with fixed K/Q. net investment occurs only
when it is necessary to increase the stock of capital in order to change
output.
It is expected that when national income in the economy is failing, there
will be no incentive for the businesses to invest in order to replace old
capital productive facilities as they wear out. There will also be no
incentive for any investment in new (capital) productive facilities by
prospective investors.
Basically, the accelerator effect ca work in the reverse direction, which
can also affect the aggregate level of employment negatively. For
instance, a slow down in consumer demand can create excess production
capacity and may lead to a fall in planned investment.
Capital investment in a certain sector of the economy can slow down as
a result of economic downturn, which spells a vast amount of spare
production capacity. This is an under-utilisation of productive resources
resulting from economic downturn. The downturn (economic) situation
will lead to a sharp fall in capital investment spending.
38
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MACRO-ECONOMICS
The implication for the economy is that there will be loss of jobs; as a
result of retrenchment of workers across the firms operating in the
industry. Hence, as the accelerator mechanism working in reverse
direction, there will be reduction in the aggregate level of employment;
an unemployment situation in the economy.
The above economic scenario requires the intervention of the
government in terms of taking ameliorative measures which can ensure
positive accelerator effect; thus reversing the unemployment situation
and enhancing the aggregate level of employment in the economy.
1.
2.
Explain the accelerator principle.

Explain how the accelerator effect can work in reverse direction.
3.2.2 Limitations of the Accelerator Principle

There are some limitations inherent in the accelerator mechanism. These
are as follows:
(i)
An increase in sales may be expected to be temporary. To this

effect, new investment may not take place since overtime work or
extra shifts would lead to expansion in the level of output. And
this may not be desirable for the firms.
(ii)
The accelerator principle does not provide for the fact that
investment at any point in time can be restricted by a change in
the capital invested. This negates the principle.
(iii)
The definition of investment by the accelerator principle

emphasizes capital widening, but is silent on capital deepening as
it assumes capital-output ratio to be fixed.
(iv)
The accelerator principle can work in the reverse direction,

which negates its desirability in the economy since such
situation leads to loss of jobs and thus increase in the
unemployment level.
(v)
There can be increase I the demand for certain goods and

services of which the industry may not be willing to increase
their investment in order to exploit the consumers. This negates
the principle of accelerator effect.
39
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MACRO-ECONOMICS

Identify and discuss the limitations of accelerator principle.
4.0
CONCLUSION
Multiplier and accelerator are macroeconomic variables that affect the

operations of the industries in the economy given an increase in the
demand for goods and services as a resulting of increase in aggregate
level of income.
Essentially, therefore, both multiplier and accelerator are
macroeconomic demand-management variables which are amenable for
use in propping up investment capacity of the industries in the face of an
increase in the aggregate level of income in the economy. The purpose
is to enhance consumer spending and subsequently the level of
productive capacity of industries and the overall aggregate level of
employment in the economy.
5.0
SUMMARY
This unit has been used to discuss important macroeconomic demandmanagement variables. Therefore, the multiplier mechanism in terms of
its process and effect on the economy has been discussed in this unit. In
addition, accelerator principle as the twin macroeconomic demandmanagement variable has also been discussed in this unit. The
discussion examined the process of the accelerator mechanism and its
inherent limitations. The next study unit is used to discuss inflation and
deflation as well as a related term of stagflation.
6.0
1.
2.
Differentiate between multiplier and accelerator.

Mention and explain the limitations of the accelerator
mechanism.
7.0
Lipsey, R. (1992). An Introduction to Positive Economics. Seventh

Edition. Weidenfeld & Nicholson Ltd.
Bonnet, P., D. Birmingham, D. Herbert (1980). Understanding
Economics., David McKay & Co. Inc.
Marris, R, (1964). The Economic Theory of Managerial Capitalism.
Macmillan.
40
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UNIT 2
MACRO-ECONOMICS
INFLATION AND DEFLATION
CONTENTS
1.0
2.0
3.0
4.0
5.0
6.0
7.0
Introduction
Objectives
Main Content
3.1 Inflation
3.1.1 Meaning of Inflation
3.1.2 Nature of Inflation
3.1.3 Types of Inflation
3.1.4 Effects of Inflation
3.1.5 Control of Inflation
3.2
Stagflation
3.3
Deflation
3.3.1 Meaning of Deflation
3.3.2 Effects of Deflation
3.3.3 Deflationary Gap and its Control
Conclusion
Summary
1.0
INTRODUCTION
Inflation which today continues to confront policy-makers throughout

the world in the form of dominant economic problem is as a result of
rising prices. Throughout the ancient period, the civilized world
frequently experienced higher prices in terms of metallic currency due to
the discoveries of new mines and the improved methods of mining gold.
The metallic inflation which followed the discovery of America
constituted one of the most important instances of inflation in history.
Hyperinflation in Germany in 1923 with its devastating effects is also an
important instance of inflation in economic history.
This study unit discusses the nature, types and effects of inflation. This
unit also discusses deflation as opposite scenario to inflation as well as
stagflation.
2.0
OBJECTIVES
explain the meaning and nature of inflation

identify and explain various types of inflation
mention and discuss the effects of inflation
41
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MACRO-ECONOMICS
identify and explain appropriate measures for controlling

inflation
explain the meaning of stagflation and deflation.
3.1
Inflation
3.1.1 Meaning of Inflation

A simple understanding of inflation is that it is a condition which
produces a rising trend in the general price level in the economy.
Nevertheless, inflation may be present in the economy if the sustained
price rise, which would have otherwise occurred, is prevented from
occurring by imposing various price and physical controls in the
economy. Such a situation is called 'suppressed inflation.
According to the Chamber's Twentieth Century Dictionary, inflation is
an undue increase in the quantity of money in proportion to buying
power, it is an excessive issue of fiduciary money. Gardner Ackley has
defined inflation "as a persistent and appreciable rise in the general level
or average of prices." According to this definition, a sporadic price spurt
or an imperceptible rise in prices will not be inflation. Elaborating
further, Ackley has stated, "We define inflation as rising prices, not as
'high' prices. In some sense, then inflation is a disequilibrium state; it
must be analyzed dynamically rather than with the tools of statistics."
According to Crowther, inflation is a state in which the value of money
is falling, i.e., prices are rising.
According to Pigou, inflation exists "when money income is expanding
relatively to the output of work done by the productive agents for whom
it is the payment. In general, inflation may, therefore, be defined as a
sustained rise in the general level of prices brought about by high rates
of expansions in aggregate money supply. Nevertheless, in
contemporary discussions of inflation it is defined as a sustained rise in
the general level of prices, however generated. All these definitions have
a common feature stressing the point that inflation is a process of rising
prices, and not a state of high prices, showing a state of disequilibrium
between the aggregate supply and the aggregate demand at the existing
or current prices, necessitating a rise in the general price level.
According to the market laws of supply and demand, an increase in
prices per se should not be inflationary. Indeed, if anything, it should be
anti-inflationary because consequent upon a given price rise, the total
amount of goods and services demanded should decrease while the
amount supplied should increase. This must be so unless the aggregate
demand and aggregate supply functions are perfectly inelastic.
42
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MACRO-ECONOMICS
Inflation can arise in the economy on account of the increase in the

money incomes of certain sections of the community without any
corresponding increase in their productivity giving rise to an increase in
the aggregate demand for goods and services which cannot be met at
current prices by the total available supply of goods and services in the
economy.
Explain the term inflation.
3.1.2 Nature of Inflation

A sustained rise in prices of about 2 per cent per year may be called
"creeping" inflation, to distinguish it from "galloping" (or "hyper")
inflation, which occurs when monthly price rise is of the order of 50 or
60 per cent or more, and from "trotting" inflation in which the price rise
occurs at intermediate rates. The basic characteristic of creeping
inflation is that the annual price rise is almost imperceptible so as to be
lost sight of by casual observers. Any complacency in controlling the
creeping inflation is likely to prove disastrous for the economic and
political stability of the economy because creeping inflation must
eventually accelerate through the trotting stage until it is galloping at
ever faster rate, culminating in the complete collapse of the currency and
the consequent disruption of the political and economic life of the
country.
Such a hyperinflation in which, due to the astronomical rise in the prices
of goods and services, money becomes almost worthless causing
unbelievable hardships to people, had been witnessed in Germany in
1923, in Hungary in 1947, and in China in 1949. In hyperinflation it
becomes undesirable to hold money for even the precautionary or
speculative purposes as real capital losses as cash holdings become
prohibitive.
For a milder sustained price rise, economists have used the terms
walking inflation and running inflation. In the case of walking inflation,
a sustained price rise may be around 8-10 per tent per year. For higher
two-digit sustained annual price rise, the term 'running inflation' may be
used. Thus, it is the rate of price rise that justifies our calling a particular
situation as one of creeping, walking, running or of hyperinflation and
sometimes there may be a good deal of overlapping between these terms
depending upon the rate of price rise adopted for purposes of
classification.
43
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MACRO-ECONOMICS
In hyperinflation the price increase is so rapid which shows that the

annual rate of price rise is almost infinite, showing that there is almost
no limit to price rise. In hyperinflation when, due to almost astronomical
price increases, money becomes worthless, people revert back to barter
or adopt some other country's money unit whose value is relatively
stable to express deferred payment contracts. This happened in Germany
when deferred payment contracts were expressed in American dollar
instead of the German Mark which had become worthless.
The climax of hyperinflation is reached when the flight from currency
becomes so fantastically high that the velocity of money in circulation
approaches infinity. In the case of running inflation, the increase in
prices is relatively mild although it is quite high compared to that under
walking and creeping inflations. The price rise is least in creeping
inflation as the slope of the curve is gentle.
We have associated inflation with a situation of sustained rising prices.
It is not, however, the only meaning which has been given to inflation in
the past. For the quantity theorist, for instance, inflation was
synonymous with an increase in the quantity of money which, on the
assumption of given velocity and transactions, caused a rise in the
general level of prices. This means that a rise in prices is the effect of
inflation and not inflation itself.
In a closed economy with low inventories and absence of institutional
barriers to price rise, the excess of aggregate demand over aggregate
supply would certainly cause rise in prices. It is, however, the excess
demand which would be inflation and the rise in prices would merely be
the symptom indicating its existence. However, excess demand need not
necessarily lead to a rise in prices.
In an open economy it can be satisfied by increasing the imports with
the result that so long as it is possible to finance a balance-of-trade
deficit the price level will not rise even in the face of an excess demand
phenomenon in the economy. Furthermore, a sustained price rise can be
occasioned by factors other than excess demand at full employment and
it would be wrong to refuse to call such price rise inflation on the
ground that this has not been caused by excess demand.
Explain the following terms:
1.
2.
3.
44
Creeping Inflation
Running Inflation
Hyper Inflation
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MACRO-ECONOMICS
3.1.3 Types of Inflation

1.
Open and Suppressed Inflation
Inflation in an economy can be regarded as open or suppressed. Inflation

is open when there is no barrier to price rise and it exists in the economy
in the absence of government control on price rise. According to Milton
Friedman, open inflation is an "inflationary process in which prices are
permitted to rise without being suppressed by government price control
or similar techniques." The post-war hyperinflations during the 'twenties'
of the present century in Germany, Austria and Russia or in China in the
'forties' are cases in point.
On the other hand, suppressed inflation exists in the economy in those
conditions in which consequent upon adopting policies of effective price
control and rationing of essential goods by the state, price increases are
suppressed. However, the prices so controlled rise with vengeance on
the removal of these controls. In suppressed inflation the symptoms of
open inflationrising pricesare replaced by long queues of buyers
waiting for their turn at government-run fair price and rationing shops
and by other forms of non-price rationing while the economy continues
to be afflicted with an inflationary problem.
Indeed, the economy is likely to suffer with greater affliction under
suppressed inflation than under open inflation since: (i) the equilibrating
effects of rising prices are eliminated in suppressed inflation, and (ii)
expectations of future commodity shortages are more likely than are
expectations of rising prices to increase the excess demand.
War-time government controls on commodity prices are examples of
suppressed inflation while post-war inflations which emerge on the
removal of price controls are examples of suppressed inflation, which
develops into an open inflation with vengeance.
The word 'suppressed' connotes postponement of present demand to
future and diversion of the demand from one good to anotherfrom
those goods whose prices are controlled and whose demand is rationed
to those whose prices are not controlled and whose demand is not
restricted through rationing.
Suppressed inflation suffers from many evils. Firstly, it creates many
difficult administrative problems. A hierarchy of price controllers,
supply and rationing officers with their many assistants, whose job it is
to administer controlled prices and supervise the distribution of rationed
goods, comes into existence. This raises the difficult problem of having
an efficient, alert and free-from-corruption price control and rationing
administrative set-up.
45
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Experience of actual working of the price control and rationing schemes

in the advanced countries like England, particularly during the period of
war, and some of the underdeveloped countries like Nigeria shows that
the rationing and price control administration is inefficient and easily
corruptible. Nearer home is the unhappy experience of our own country
in the 1980s where consumers were subjected to innumerable hardships
due to the conspiracy between the price control administration and the
hoarders selling controlled-price scarce consumer goods at black-market
high prices, both becoming rich at the expense of the poor consumers.
Most times, black market develops through which controlled price
goods are sold and the authorities become parties to the lucrative illegal
activities of the black-marketers. The authority being a party to the
profitable activities of the black-marketers, there soon develops a hidden
price inflation, which is more dangerous than the open inflation,
underneath the suppressed inflation.
It is, therefore, obvious that in the hands of corrupt and inefficient price
control and rationing administration, manned by bureaucrats having
little or no business acumen, suppressed inflation erupts after some time
into severe open inflation. The appearance of black market in the
economy is a cumulative process; once it appears it feeds upon itself.
The existence of such a market gives rise to two parallel modes of
transacting business one in the legal manner in the open market and
the other in an illegal manner in the black-market, the latter becoming
more important than the former.
Empirical evidence indicates that excess purchasing power then causes a
violent price inflation in the black markets, while the legal markets are
drained of merchandise. Once the population finds that it cannot even
buy its modest rations, black market operations become the
preoccupation of everybody. Where one such black market transaction
earns more money than a week's or a month's hard work, productivity
will decline."^ Black markets and low public morale are the by-products
of suppressed inflation.
Suppressed inflation also diverts economy's scarce productive resources
away from the essential goods producing industries whose prices are
statutorily fixed towards those industries which produce relatively nonessential goods whose production becomes more profitable since the
prices of such goods are free to rise. The diversion of community's
scarce resources away from the production of essential goods towards
the production of relatively non-essential goods runs counter to the
optimum-use theory of community's scarce resources causing
diminution in community's total welfare. In short, scarce resources are
46
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MACRO-ECONOMICS
not optimally allocated leaving much to be desired from optimum

community welfare point of view.
According to Milton Friedman, suppressed inflation is worse than open
inflation. Taking the post-war Germany for his illustration, Friedman
has pointed out that in Germany after World War II prices were not
allowed to rise although by usual standards there existed a substantial
inflationary potential. If prices had been allowed to rise freely
immediately after the war, the price level would have probably
quadrupled which by any standard would be a large price rise. The price
rise was, however, suppressed.
Ordinarily, it is extremely difficult to suppress a price-rise of this
magnitude and to enforce price control when the free market price
would be four times the controlled price. But there were certain
especially favourable circumstances in Germany in the post-war period
from the point of view of enforcing price control. Germany was at this
time occupied by the armed forces of France, Britain, and USA. The
occupation forces effectively enforced price control. As a consequence
of the strict enforcement of price control, output in Germany was
halved. The price system was prevented from functioning and people
reverted to barter.
During such period people worked for two or three days in a week
producing aluminum pots and saucepans in factories and spent the rest
of the weekdays selling these saucepans, which they had been given as
their pay by the factory owners, to the country-side farmers in exchange
for potatoes or some other farm produce. Being a very inefficient mode
of organizing resources people tried to change it by developing their
own forms of money. Cigarettes began to be used as money for small
transactions while cognac was used as money to conduct large
transactions. Not withstanding this expedient, the output was halved
compared to the output immediately at the end of the war due to
suppressed inflation.
The reason for the so much disastrous nature of suppressed inflation is
explained by the fact that price system is the only technique which has
so far been discovered or invented for efficiently allocating the
.resources between different competing uses and unfortunately the price
system is prevented from operating. The clumsy physical controls which
are substituted to replace the price system fail miserably to serve the
function of an efficient allocator of scarce resources in the economic
system.
Differentiate between open inflation and suppressed inflation.
47
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2.
MACRO-ECONOMICS
Demand-Pull Inflation
This type of inflation, which is also known as excess demand inflation,

occurs when aggregate demand exceeds aggregate output in the
economy. Since quantity of goods produced cannot cope with aggregate
demand in the economy, there will be general rise in the price level.
According to classical economic analysis, the price level depended
directly and proportionately on the supply of money. Inflation,
according to the classicists, occurs when the quantity of money
increases and comes to a halt when the quantity of money becomes
stable. The rate of inflation will depend upon the rate at which new
money is created. This is the quantity theorist's explanation of the
inflationary process.
Keynes's analysis of the excess-demand inflation assumes aggregate
demand to exceed the aggregate supply at full employment level.
Starting with the situation of full employment equilibrium, if investment
demand increases then the aggregate demand for goods and services will
exceed their aggregate supply at full employment level assuming a given
level of prices at constant prices. This is the situation of disequilibrium
which can be corrected only either through increase in the prices or
through increase in the aggregate real output or through increase in both
the prices and output. But since under our assumption the economy is
already operating at full-employment no increase in aggregate output is
possible.
Consequently, prices will rise sufficiently so as to bring about
equilibrium between aggregate demand and aggregate supply. Since
consumer demand is a function of real income, the excess demand will
persist because the rise in prices raises people's money incomes as result
of which the real income remains unchanged. Keynes severed the close
relationship between the quantity of money and the level of aggregate
demand by showing that even with constant money supply some
inflation may be experienced. With the total quantity of money held
constant, an increase in prices occasioned by increased aggregate
demand would raise the transaction demand for cash balances.
3.
Cost-Push Inflation
The cost-push inflation occurs due to the increase in the cost of supply
price of goods, caused by increases in the input costs. According to this
explanation, rapidly rising wage levels, unaccompanied by
corresponding increase in labour productivity in certain key sectors of
the economy become reflected in higher prices in these same sectors,
particularly as demand recovers.
48
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Consequent upon the above situation, the purchasing power of wages

becomes eroded causing organized labour, including trade unions not
involved in the initial round of wage increases, to seek redress in the
form of further wage increases through their collective bargaining
strength. The most common political expression of this view is based on
the plea that monopolistic trade unions cause inflation by bidding up
wages through exercising their superior collective bargaining power.
Stated in terms of the aggregate demand and aggregate supply functions,
the cost-push inflation emerges in the economy, in the absence of excess
demand, due to the pressure of various factors which shift the aggregate
supply function upwards.
The two main factors responsible for the upward shift in the production
costs are: (i) the higher money wages secured for their members by the
labour unions without any corresponding increase in their productivity,
and (ii) the higher prices charged from consumers by the monopolistic
and oligopolistic producers. The upward shift in the aggregate supply
function and the resulting rise in the general price level due to the first
factor is designated as the 'wage-push' inflation to distinguish it from the
'profit push' inflation resulting from the operation of the second factor in
the economy.
Generally speaking, the cost-push inflation in the economy occurs as a
result of the combination of both the wage-push and the profit-push
factors. According to those who hold that prices are pushed up by rising
costs rather than by the demand-pull forces, some control in the form of
prices and incomes policy is necessary to bring the spiral of rising prices
to halt.
Both the demand-pull and the cost-push explanations of inflation are
closely linked with the now widely held view that the problem of
inflation is more sociological than economic in nature. In recent years,
workers' and consumers' expectations have risen considerably far
beyond the scope of existing productive capacity to meet their demands.
A mounting stream of government transfer payments and increased
government involvement have largely contributed to increased
consumption directed to sap both individual initiative and the ability and
incentive of the private enterprise sector to undertake the needed
commitments to modernize and expand the economy's productive
capacities.
Differentiate between cost-push inflation and demand-pull inflation.
49
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4.
MACRO-ECONOMICS
Internationally Generated Inflation
It has been frequently argued by governments that inflation is not

generated domestically but is rather an international phenomenon
beyond their control. This view of inflation seeks to ascribe the price
rise to international forces. Some economists believe that this type of
inflation creeps into other countries as a result of global trade.
For instance, as a result sudden and perceptible rise in petroleum and
petroleum-based products' prices in recent times, many countries have
experienced inflation that can be ascribed to international price
pressures. While it is true that international forces may contribute to
inflationary pressures in any economy, particularly in an economy
which is highly dependent on the outside world, at the same time it
cannot be denied that inflationary pressures in the economy are chiefly
fed by domestic factors.
5.
Ratchet Inflation
Ratchet inflation emerges in the economy when although the aggregate

demand is not excessive, it is so distributed in the economy that it is
excessive in certain sectors of the economy and inadequate in others. In
an economy with perfectly flexible wages and prices, prices would rise
in those sectors where the demand was excessive and fall in those others
where the demand was inadequate, keeping the general level of prices
unchanged. However, due to price "administration" by strong trade
unions and oligopoly industries prices tend to be rigid in downward
direction. Thus while prices in the excess demand sectors rise, these do
not fall in the deficient demand sectors. The net effect is a rise in the
overall price level. Excess demand bids up prices while the administered
wages and prices provide the ratchet preventing compensating fall in the
prices elsewhere in the economy.
The ratchet process can be understood by assuming that an economy is
composed of the 'light' industry and 'heavy' industry sectors. Let us
assume that initially the demand in each industry is equal to the full
potential output of each industry. Now suppose that a shift in the
demand away from light industry to heavy industry takes place.
Consequent upon this shift in the intersectional demand, prices in the
heavy industry, where the demand is excessive, will rise while prices in
the light industry where the demand has fallen will not register any fall
due to downward price-rigidity. Consequently, the aggregate price level
in the economy will be bidden up.
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MACRO-ECONOMICS
Mark-up Inflation
Holzman, Duesenberry, Ackley and some other economists have

ascribed inflation to the practice of business corporations to compute
costs and then add to these costs a certain mark-up to yield a given
"target return" on the invested capital or sales. Mark-up pricing is a type
of administered price-fixing, which as explained by some economists,
leads to inflation.
According to Ackley, the mark-up approach "places the emphasis where
unions and businessmen place it, not on the level of prices per se, nor on
supply and demand, but on the preservation of 'fair' relationship between
buying prices (including the cost of living), and selling prices including,
wage rates." In Ackley's view, when demand is higher the mark-up tends
to be higher, about equal to cost increases, and less (but not too much)
when demand is low and costs are high. An important point made by
mark-up inflation theorists is that what is important is the process by
which increases in prices and wages occur and not where the increases
in prices initially occurred.
Differentiate between Ratchet inflation and Mark-up inflation.
3.1.4
Effects of Inflation
Many aspects of our everyday activities are in many ways influenced by

the level of and changes in the rate of inflation. Consumers' real
disposable personal incomes and consequently their spending capacity
are significantly affected by changes in wages and prices. During
periods of mild inflation consumers sometimes react by cutting their
spending on luxury and other non-essential goods while in times of
severe inflation substantial anticipatory buying or hoarding becomes a
common feature as people shift from financial to real assets.
The business sector is also affected by inflation. During inflation,
corporate and non- corporate profits rise sharply and businessmen react
to rising prices by building up inventories. Inflation also affects the
government sector in a number of ways. As prices rise, revenues yielded
by indirect taxes also increase. Moreover, under a progressive direct tax
system revenues from income taxes will rise at a faster rate than the
growth rate of nominal incomes. Consequently, large transfer of
resources from households to the government takes place.
Inflation not only affects the income and expenditure pattern of the
major sectors of the economy but it also alters the existing pattern of
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distribution of wealth, making some groups better off relative to others.

For example, debtors gain while creditors suffer. People dependent upon
fixed incomes, such as pensioners, suffer most from inflation and their
share of the national income inevitably declines unless they receive
special assistance.
Inflation initially activates the economy. A business boom in its early
stages causes only a modest rise in the cost of living of the people while
it raises the level of employment in the economy. However, continuous
inflation shakes the foundations of the political and economic stability
of the system. It causes inequitable and arbitrary redistribution of
income and wealth in society. The worst sufferers are the recipients of
fixed incomes by way of salaries, pensions, and annuities. With respect
to wealth, inflation inflicts losses on holders of government bonds, on
holders of fixed deposits in banks, and on holders of life insurance
policies and money.
To the holders of money, inflation adds to the cost of holding money as
general price level in the economy rises. A continuous inflation can
reduce the value of money to almost nothing, ruining the holders of
money. Inflation wipes out savings completely. The social consequences
of hyperinflation are no less terrifying than are its economic effects.
Debtors liquidate their past debt obligations by offering worthless
currency to their creditors. The value of accumulated cash savings
evaporates. Hyperinflation replaces industry and thrift with hoarding
and speculation.
Hyperinflation reaches its climax when the flight from money is such
that the velocity of money approaches infinity. In Germany during the
hyperinflation in 1920s life's entire savings could not buy even a cup of
coffee. Consequently, periods of substantial inflation are characterized
by low public morale.
Identify and explain the effects of inflation.
3.1.5 Control of Inflation

The phenomenon of inflation is frequently controlled by resorting to the
instruments of monetary and fiscal policies. According to the classical
quantity theory approach, demand inflation can be controlled by
resorting to an appropriate monetary policy so as to halt expansion of
the money supply.
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According to the Keynesians, however, the monetary policy alone will

not be able to check inflation. Consequently, it is suggested to apply the
restrictive fiscal policy instruments of curtailing unproductive
expenditure and widening and deepening the tax structure in the
economy.
Since the cost-push inflation is largely caused by rising cost, supply
inflation can be controlled by maintaining wage-rate stability by
preventing those wage increases which are not related to the increase in
labour's productivity.
A restrictive policy may check a wage-push inflation provided it reduces
the aggregate demand and output sufficiently to create enough
unemployment to prevent wage increases in excess of the increases in
labour's productivity.
There is the 'deferred pay scheme' which was first suggested by Keynes.
The amount credited to workers' saving accounts would remain blocked
so long as inflation lasted and would be released when recession started.
This scheme is a price stabilizing scheme as it aims to arrest both
inflation and deflation.
The excess aggregate demand may also be controlled by introducing
price control and compulsory rationing of essential goods in short
supply. In a free society, these schemes are vehemently opposed by the
people.
Used as anti-inflationary measures, the monetary and fiscal policies act
as complimentary parts of anti-inflationary economic policy. Monetary
policy which consists in controlling the supply and cost of money by the
central bank is enforced by using different monetary instruments.
An important monetary policy instrument available to the central bank
to curtail the supply of credit is the bulk sale of securities as part of its
open market operations policy. The bulk sale of securities to the public
and banking community by the central bank directly reduces the total
amount of cash balances in public's asset portfolio and cash reserves
with the commercial banks. The fall in the cash reserves of the banks
forces them to reduce their total advances.
The indirect effect of open market sales of securities is seen in the rise
of the interest rates. To the extent that investment is interest-elastic this
will check excess investment activity and help in containing the
inflationary pressures in the economy.
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Raising the bank rate is another monetary policy instrument, which is

used by the central bank to control inflation. Bank rate is central bank's
lending rate which member banks must pay on their borrowings from
the central bank against approved securities. A rise in the bank rate
shows that central bank's monetary and credit policy is being directed
toward credit squeeze to control inflationary forces in the economy.
The central bank can also restrain excessive credit expansion by the
commercial banks as part of its anti-inflationary monetary policy by
raising the minimum legal cash reserves required to be kept by the
commercial banks with it. A rise in the minimum legal cash reserves
ratio raises the total amount of cash balances which the bank must keep
against their deposits with the central bank. This action will force the
banks to curtail their total advances. The use of this power by the central
bank forces the commercial banks to exercise greater caution in their
lending activities and thus reinforces restrictive credit policy.
The central bank may resort to enforcing a policy of selective credit
control. Selective credit control policy which takes the form of issuing
directives to the commercial banks prohibiting them from lending
against certain commodities or reducing the total credit limits sanctioned
by the banks against certain commodities or in certain regions seeks to
curb inflationary pressure in selected economic activities.
Devising a suitable tax policy directed toward restricting demand
without discouraging production is a form of fiscal measure which can
control inflation. Heavy excise duties on items of mass consumption
which withdraw excess purchasing power from consumers without
discouraging expansion of productive capacity provide a convenient
method of restricting aggregate demand to aggregate available supply.
Postponing or curtailing government expenditure on unproductive
public works will have a stabilizing effect in an inflationary period
because such expenditure competes for resources with expenditure
undertaken to expand productive capacity elsewhere in the economy.
Unless the public works schemes add substantially to economy's
productive capacity these should be deferred to be resumed in a period
of slack activity and falling prices.
A judicious blending of monetary and fiscal policies requiring close
cooperation between the central bank and the treasury can prove
effective in controlling inflation in the economy if applied at proper
time.
Wage-price freeze, temporarily during inflation, has also
been
suggested by some as a measure against inflation. To eliminate the
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distributional injustice inflicted by inflation it has been suggested to

introduce cost of living escalation clause into all contracts. If wages,
salaries, pensions, contracts, were subject to the price escalation clause,
the distributional effect of inflation would be largely eliminated.
On a final note, it is sometimes argued that since the ultimate causes of
inflation are political and sociological rather than economic in nature, it
is in the political and social adjustments that answer to the inflation
problem must be found. It must also be recognized that while many
international and special influences may provide spur to inflationary
pressures, in the final analysis inflation is a domestic problem in each
country and it can be checked by means of responsible government
economic policy, monetary and fiscal, as well as through special efforts
aimed at expanding the productive capacity of the economy.
Identify and explain the various measures which can be used to control
inflation.
3.2
Stagflation
The term 'stagflation' is a recent arrival in economic literature derived

from joining together the 'stag' of stagnation and 'nation' of inflation.
The term has been coined by economists to explain the recent
paradoxical inflationary phenomenon in which sustained and substantial
price increases have been accompanied by declining output and rising
unemployment.
During the early 1970s most countries' governments were under strong
political pressure to adopt expansionary programmes in order to reduce
unemployment, and it seems likely that the eventual effect of the 1971
exchange rate realignment was to encourage a higher rate of output
expansion associated with a higher rate of price increase than before
1971. The large and erratic changes that followed the abandonment of
fixed exchange rates in 1973 acted as a check on the increase in real
output by increasing uncertainty, and thus contributed to the unexpected
severe downturn in 1975.
Restrictive financial policies adopted in order to curb the very rapid
rates of inflation experienced in 1973 and early 1974 were associated
with unusually severe declines in output and employment and with little
or no fall in prices and wages. In short, substantial declines in output
and employment coexisted with price and wage inflation in most world
economies, particularly in the industrially advanced countries of the
world. This situation was different from that of chronic inflation which
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was ubiquitous in developing countries during the 1950s and early

1960s.
Differentiate between inflation and stagflation.
3.3
Deflation
3.3.1 Meaning of Deflation

Deflation is regarded as a persistent downward movement of prices in
general over a period of years. In other words, deflation may be defined
as a state in which prices are falling, that is, the value of money is rising
in the economy. Since deflation refers to the movement of prices, it is a
monetary term.
Furthermore, since the downward movement in prices must be
persistent, any sporadic decline in prices cannot be termed deflationary.
Moreover, deflation is usually associated with falling economic activity
and employment, nevertheless, the association is not rigid because it is
possible to have depression without deflation.
3.3.2 Effects of Deflation

The presence of deflation in the economy is indicative of disequilibrium
which has serious disturbing effects in the system. Apart from causing
comprehensive changes in the total productive activity and consequently
in the total output and employment in the economy, deflation causes an
arbitrary redistribution of real income and wealth among various classes
of people causing disharmony in society.
Falling prices force businessmen to reduce their inventories in the face
of persistently sagging demand. Speculators rush to unload their holdings in order to "cash in" their paper profits. Wage earners cut-back their
spending in order to save enough to fall back upon in period of
unemployment which they foresee will soon engulf the economy. In
course of time, a general "flight" from goods and other real property to
money takes place, productive equipment grinds to a halt, factories are
closed and workers are thrown out of employment.
Furthermore, businesses are liquidated and economy's entire productive
structure is paralyzed. Not only does total output contract in period of
deflation. Moreso, the fact that the shares in the gross national product
going to different functional groups change haphazardly, it rewards
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some groups and punishing the others, regardless of the merits or

demerits of the recipients.
The share of the GNP claimed by the workersthe active factor of
productiondeclines both in relative and absolute terms on account of
drastic fall in wages and employment. The rentier class claims a higher
share in the total product since rent and interest remain relatively fixed.
Entrepreneurs suffer losses. The real burden of debtpublic and private
increases. Like income, wealth is also arbitrarily redistributed in
favour of the rich rentier class which receives more in real terms by way
of repayment of principal sum and payment of interest, on old loans.
3.3.3 Deflationary Gap and its Control

Deflationary gap appears in the economy when total spending at the full
employment level is insufficient to maintain that level of income. It can
be defined as the amount by which total spending in the economy falls
short of the full employment level of income at existing prices.
The existence of deflationary gap in the economy is of great significance
since it can and does cause employment and income to fall in the
economy. Deflationary gap implies that the leakages from the national
income flow in the form of taxes (government's disposable income) and
savings exceed the injections of investment and government spending.
A given amount of deflationary gap forces the national income to fall by
more than the amount of the gap. This is, somehow, related to the fact
that as income falls consumption also does as stated by the consumption
function.
You have appreciated that basically the problem of deflation arises from
the deficiency of the total spending which at full employment level of
income is less than the level of that income. Consequently, to remove
deflation economic policy measures should aim at raising the level of
aggregate effective demand sufficiently so as to make it equal to the full
employment level of national income.
Both the fiscal policy and monetary policy should be deployed for the
purpose. Government spending should be raised while taxes should be
reduced so as to raise peoples' total disposable income as a consequence
of which aggregate consumption will increase.
Corporate and non-corporate business investment may be raised by
providing various tax incentives while lowering the interest rates to be
charged by banks on business loans. A massive public works
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programme aiming at increasing government spending without causing

any adverse effects on private spending should be executed.
For instance, the 'New Deal' programme executed by the Roosevelt
administration in the US to rid the American economy of the intractable
depression of the 1930s shows that public works policy carefully
planned and boldly executed can serve as an effective cure for deflation
in the economy.
Mention the effects of and measures for controlling deflation.
4.0
CONCLUSION
From the foregoing analysis, you can understand the nature of inflation
and its effects on the economy. You can also understand the various
types of inflation and the appropriate measures which can be used to
control inflation in any economy. Lastly you can also understand the
meaning of deflation as well as stagflation and its variance with
inflation.
5.0
SUMMARY
This study unit has been used to discuss the meaning and nature of
inflation. In this unit, discussion is given to the various types of inflation
and relevant measures which are necessary for controlling inflationary
trend in any economy. The unit is also used to discuss the various effects
of inflation in the economy. Lastly, the unit also explains the meaning of
stagflation as well as deflation and its effects in the economy.
6.0
Identify and discuss various types of inflation.
7.0
Begg, D., S. Fischer and R. Dornbusch (2000). Economics. Sixth

Edition. Berkshire England: Maindenhead.
Lipsey, R.G.and K.A. Crystal (1997). An Introduction to Positive
House Pvt Limited.
UNIT 3
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CONTENTS
1.0
2.0
3.0
4.0
5.0
6.0
7.0
Introduction
Objectives
Main Content
3.1
The International Bank for Reconstruction and
Development (IBRD)
3.1.1 Establishment of International Bank for
Reconstruction and Development
3.1.2 Functions of International Bank for Reconstruction
and Development
3.1.3 Membership and Organization of IBRD
3.1.4 Lending Operations of IBRD
3.2
The International Monetary Fund (IMF)
3.2.1 Establishment of International Monetary Fund
(IMF)
3.2.2 Purpose of International Monetary Fund
3.2.3 Structure of International Monetary Fund
3.2.4 Mode of Operation of IMF
3.2.5 Determination of Par Values of Member Countries
Currencies
Conclusion
Summary
1.0
INTRODUCTION
The aftermath of the World War II saw the setting up of a number of

international institutions in the economic field such as the Food and
Agriculture Organization, the International Bank for Reconstruction and
Development, International Finance Corporation, International
Development Association, etc. In the field of international trade, the
effort was made for the adoption of the Charter for International Trade
Organization at the Havana Conference on Trade and Employment.
In this unit, our discussion is centered on the analysis of the most
prominent financial institutions established after the World War II to
deal with economic and financial development of the world economy.
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2.0
MACRO-ECONOMICS
OBJECTIVES
explain the rational for the establishment of IBRD

identify and explain the functions of IBRD
discuss nature of membership, organization and lending operations
of IBRD
discuss the reasons for the establishment of IMF
identify and explain ways through which IMF helps member
countries.
3.1
The International Bank

Development (IBRD)
for
Reconstruction
and
3.1.1 Establishment of International Bank for Reconstruction

and Development (IBRD)
The International Bank for Reconstruction and Development, popularly
known as the World Bank, owes its birth to the deliberations of the
United Nations Monetary and Financial Conference which met at
Bretton Woods, New Hampshire, to prepare the final text of the Articles
of Agreement of the International Monetary Fund and the International
Bank for Reconstruction and Development from 1 .July to 22 July 1944.
The World Bank was established on 25 December 1944 when the
Articles of Agreement were ratified by the requisite number of member
governments.
The global war had completely dislocated the multilateral trade and had
caused massive destruction of life and property. The economies of
England and other European countries had been completely shattered.
While the need for promptly reconstructing the war-damaged economies
of European countries was recognized, it was also recognized that a
lasting world peace was threatened from the great disparities in incomes
and wealth manifested in the wide differences in the standards of living
between the developed and the underdeveloped countries. Consequently,
the problem of raising the standard of living of the vast masses of people
of underdeveloped countries brought to fore the need to develop rapidly
the economies of these countries. Thus the Bretton Woods Conference
was also responsible for establishing the International Bank for
Reconstruction and Development.
Trace the origin of the World Bank.
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3.1.2 Functions of International Bank for Reconstruction and

Development (IBRD)
The World Bank is an international corporate institution whose capital
stock is owned by its member nations. The principal functions of the
Bank are:
1)
To assist in reconstruction and development of the territories of

its member governments by facilitating investment of capital for
productive purposes;
2)
To promote foreign private investment by guarantees of or

through participation in loans and other investments made by
private investors;
3)
Where private capital is not available on reasonable terms, to

make loans for productive purposes out of its own resources or
out of the funds borrowed by it; and
4)
To promote the long- range growth of international trade and the

maintenance of equilibrium in members' international balance of
payments by encouraging international investment for the
development of the productive resources of members.
The World Bank's loans are given to help the members to build foundation of sound economic growth. Loans made or guaranteed by the Bank
are, except in special circumstances, for the purpose of specific projects
of economic development of members' economies. The Bank ensures
that the proceeds of any loan are used only for the purpose for which the
loan was granted.
The World Bank's total loans have been given for development of
electric power, development of transportation, agriculture and rura1
development, providing educational facilities, urban development,
development of industry, development finance of companies and
development of technical assistance, population planning,
telecommunications, tourism, water supply and sewerage.
Identify and explain the functions of the World Bank.
3.1.3 Membership and Organization of IBRD

Any country is eligible for World Bank's membership if it subscribes to
the Charter of the Bank. A member can withdraw at any time its
membership. Its withdrawal is, however, effective upon receipt by the
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Bank of a written notice from the member to that effect. Failure to fulfill
its obligations toward the Bank may lead to suspension of a member.
Even when a government ceases to be a member, it is obliged to repay
on demand its portion of the losses, if any, sustained by the Bank on its
operations on the date when that government ceases to be a member.
The Bank has a Board of Governors, Executive Directors, a President
and other staff. All powers of the Bank are vested in the Board of
Governors consisting of one governor and one alternate appointed for
five years by each member. No alternate can vote except in the absence
of his principal. Each governor has the voting power which is related to
the financial contribution of the government which it represents.
Although even the smallest member gets a minimum number of votes,
however, the voting power of the smaller share holders in the Bank is far
outweighed by the voting power which the big share holders enjoy.
The United States of America with her substantial subscription has
21.48 per cent of the total voting power while the United Kingdom has
8.12- per cent of the total voting power. The Board of Governors meets
once every year. Although mainly dealing with matters requiring only
formal action, the annual meeting of the Board of Governors of the
Bank is an important occasion for informal exchange of views at high
level on major international, financial and monetary problems.
Among the total of 20 Executive Directors who direct the Bank's general
operations, 5 are appointed by the 5 biggest share holders such as the
United States, United Kingdom, the Federal Republic of Germany,
Japan and Franceand the remaining fifteen are elected by the other
members. Each director holds voting power in proportion to the shares
held by his government. With certain exceptions the Board of Governors
has delegated all its powers to the Executive Directors who are
responsible for the conduct of the general operations of the Bank.
The Executive Directors function in continuous session and meet
regularly. A majority of the Directors exercising 50 per cent or more of
the total voting power constitutes a quorum. The President of the Bank
acts as Chairman of the Board of Directors. He has no vote except a
deciding vote in case of an equal division. He is the chief of the
operating staff of the Bank and is responsible to the Board of Governors
of the Bank for the conduct of the ordinary business of the Bank and its
organization. He is assisted by a number of heads of some departments.
Discuss nature of membership and organization of the World Bank.
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3.1.4 Lending Operations of IBRD

The Bank makes loans to members in one or more of the following way:
1.
2.
3.
By granting or participating in direct loans out of its own funds;

By granting loans out of funds raised in the market of a member
or otherwise borrowed by the Bank;
By guaranteeing in whole or part loans made by private investors
through the investment channels.
The total outstanding amount of the loans made or guaranteed by the

Bank is not supposed to exceed 100 per cent of its total unimpaired
subscribed capital, resources and surplus.
Before a loan is made or guaranteed the Bank ensures that:
xii.
xiii.
xiv.
xv.
The project for which the loan is asked has been carefully
examined by a competent committee as regards the merits of the
proposal;
Borrower has reasonable prospects for repayment of loan;
Loan is meant for productive purposes; and
Except in special circumstances, the loan is meant to finance the
foreign exchange requirements of specific projects of reconstruction and development.
The Bank normally makes medium and long term loans, the term being
related to the estimated useful life of the equipment or plant being
financed. The Bank keeps itself informed on the projects which it
finances by means of periodic reports received from the borrower and
through on the spot inspections by its representatives. The interest
rate charged by the Bank on its loans is the estimated cost to the Bank of
borrowing money for a comparable term in the money market and is
uniform without distinction among borrowers.
In addition to the rate of interest, the Bank charges on all loans a
commission of one per cent for the purpose of creating a special reserve
against loses and half per cent charges for meeting administrative
expenses. The bank has made loans for specific development projects in
the fields of agriculture, electric power, transport, telecommunications,
industry, population planning, water supply, project preparation,
tourism, urban development and education.
In view of the fact that the underdeveloped countries need basic
transportation and communication facilities to develop their domestic
economies and to provide new incentives for production, the Bank has
also made loans for the development of transportation. Such lending
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includes the financing of high ways construction, development of

airports and airlines, rehabilitation and development of railways,
construction of pipelines development of ports and shipping and other
modes of transportation.
Discuss the lending operations of the World Bank.
3.2
The International Monetary Fund (IMF)
3.2.1 Establishment of International Monetary Fund (IMF)

The International Monetary Fund was established with the objective of
promoting international economic stability by promoting the balanced
growth of world trade and by encouraging the multiconvertibility of
national currencies. The Fund is a pool of central bank reserves and
national currencies which are made available to Fund members under
certain conditions. In a way, the pool may be regarded as an extension
of member countries' central bank reserves.
The 1914 gold coin standard was abandoned by all the gold standard
countries during World War I. After the cessation of hostilities, the
desire was manifest among the leading world nations to return to the
gold standard which had for a long period fostered the growth of stable
international trade and economic relations. After the war, the United
States of America was the first among the gold standard countries to
return to the gold standard in 1919. The fear was, however, prevalent
that other countries might resort to competitive currency depreciation in
order to attract gold inflows.
Deflation decreases the total money supply, increasing money's scarcity
and thereby raising the purchasing power of country's money unit. Dear
money policy pursued consequent upon deflation causes an upward
adjustment in the structure of interest rates in the country. The rise in the
rates of interest accompanied by the fall in prices as result of deflation
attracts foreign capital and reduces deficit of a country's external balance
of payments. But deflation as a method of correcting adverseness of the
external balance of payments is not adopted by a country so long as
easier methods are available because deflation causes unemployment,
fall in production and income in the country.
The Economic Conference convened in Geneva in 1922 had recommended that the member countries should adopt gold standard suggesting that world's total gold reserves should be held at two or three
leading financial centres like London, New York and Paris, the other
64
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countries meeting their foreign exchange requirements by holding bank

deposits and other liquid assets at these leading centres. The Conference
had also recommended the regulation of credit in the interest of
international peace and economic prosperity.
At the time of the post-war restoration of the gold standard, the franc
was undervalued in relation to the pound sterling. Consequently France
experienced surplus balance of payments situation and accumulated
massive gold and foreign exchange reserves. This huge surplus in her
external balance of payments should have been invested abroad if
equilibrium was to be maintained. However, due to the reluctance of
French investors to make long-term investments of their foreign
balances abroad only a part of these foreign balances was invested
abroad in the form of short-term and call deposits creating the problem
of 'hot money' in the debtor countries. A substantial part of foreign
balances held by the foreign creditors in the debtor countries was
converted into gold.
The basic fact that international trade is a barter trade whereby
ultimately the payment for a country's imports is made by her exports
and vice versa was ignored by these creditor countries, particularly by
France and America. Even the richest country has only limited reserves
of gold to use in emergency to tide over deficit in her external balance of
payments position. However, the deficit in the balance of payments
experienced by the debtor countries was serious arising from
fundamental disequilibrium in their balance of payments. To correct this
deficit, massive gold outflows exhausting the entire gold holdings of the
debtor countries took place without reaching any equilibrium in the
balance of payments of these countries.
France and USA did not honour their obligations as world's leading
creditor countries. These obligations were fulfilled with sincerity by
England before World War I as the world's leading creditor nation. Gold
was imported by France and USA to be locked in the central bank
cellars and money supply did not expand as a consequence of massive
gold inflows. This in effect meant thwarting the working of the pricespecie-flow adjustment mechanism of the gold standard. Gold imports
did not exert any pressure on domestic price level in USA and France. In
the post-war world America had emerged as world's leading creditor
nation.
A creditor country must be ready to receive payments of her loans by
creating the necessary import surplus in her balance of trade, requiring
her to follow an open door policy allowing free imports into the country.
But unfortunately, United States of America became highly protectionist
shutting her seashores for imports by erecting high import tariff walls.
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An international monetary standard cannot function in a mad nationalist

world. Consequently, the international gold standard broke down
causing panic and confusion in the world.
After the breakdown of the post-war international gold standard during
the thirties, a make- shift arrangement was evolved between England,
the USA and France to achieve exchange stability by establishing
exchange stabilisation funds by the three countries. The arrangement
visualised by the Tripartite Agreement of 1936 worked until 1939.
During the war no international monetary arrangement existed. After the
breakdown of the gold standard, the world lost the most efficient
automatic monetary standard on which nations had for long relied for
restoring equilibrium in their external balance of payments. No
alternative arrangement comparable to the gold standard, however,
emerged to replace it. Instead each country dealt with its external
balance of payments deficit in her own way in a manner that resulted in
shrinkage of world trade in a world characterized by trade and payments
restrictions.
Countries increasingly resorted to exchange clearing agreements,
blocked accounts, multiple exchange rates and many other restrictions
on international trade and payments. These restrictions on multilateral
trade and payments increased in severity during the war. The
enlightened public opinion and world statesmen feared that these
restrictive trade and payments practices would continue after the war
unless concerted international efforts were made to create some effective
international machinery whereby-exchange stability could be
guaranteed. It was the outcome of such convictions shared by the
experts during the war that they prepared comprehensive plans of
international monetary cooperation for implementation after the war.
The British Plan authored by the eminent British economist John
Maynard Keynes took the shape of Keynes Plan while the plan prepared
by the American expert Henry D. White was known as the White Plan.
The basic features of the two plans were fused into a common plan
evolved at a United Nations Monetary and Financial Conference of 44
nations held at Bretton Woods, New Hampshire in July 1944. The
Conference gave birth to both the International Monetary Fund and the
International Bank for Reconstruction and Development.
According to the Conference, three main economic problems dominated
the post-war period. Firstly, in order to ensure world order and peace, it
was essential to restore stability in the monetary systems of those
countries which had been forced by the exigencies to abandon all
conventional rules of monetary discipline observed under the gold
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standard. Secondly, it was necessary to find effective means to

reconstruct the war-ravaged economies of the European countries.
Thirdly, it was realized that stable peace could never prevail in a world
in which the developed nations were unconcerned of the untold miseries
of vast sea of humanity living in the undeveloped and underdeveloped
countries of Asia, Africa and Latin America. The world was to be made
a better place to live for the masses of the poor Afro-Asian nations. This
could be achieved only by diverting a part of world resources to the
development of the economies of Afro-Asian countries.
The effective solution to the problems of reconstruction and
development was necessary for ensuring an expanding world economy
and for dismantling the complex trade and exchange restrictions that had
grown during the previous decade. The IMF was established in order to
abolish effectively all exchange and trade restrictions and to promote
multilateral trading system while the World Bank was established to
find an effective solution of the knotty problem of economic
reconstruction and development.
Discuss the formation of the International Monetary Fund.
3.2.2 Purpose of International Monetary Fund

The functions of the Fund as mentioned in the Second Amendment to
the Articles of Agreement of the International Monetary Fund, which
became effective from 1 April 1978, are as presented below:
1.
To promote international monetary cooperation through a

permanent institution; which provides the machinery for consultation and collaboration on international monetary problems;
2.
To facilitate the expansion and balanced growth of international

trade and to contribute thereby to the promotion and maintenance
of high levels of employment and real income and to the
development of the productive resources of all members as
primary objectives of economic policy.
3.
To promote exchange stability, to maintain orderly exchange

arrangements among members and to avoid competitive exchange depreciation.
4.
To assist in the establishment of a multilateral system of

payments in respect of currency transactions between members
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and in the elimination of foreign exchange restrictions which

hamper the growth of world trade.
5.
To give confidence to members by making the general resources

of the Fund temporarily available to them under adequate
safeguards, thus providing them with opportunity to correct
maladjustments in their balance of payments without resorting to
measures destructive of national or international prosperity.
6.
In accordance with the above, to shorten the duration and lessen

the degree of disequilibrium in the international balances of
payments of members.

Identify and discuss the functions of the International Monetary Fund.
3.2.3 Structure of International Monetary Fund

The Fund's structure is mentioned in the Articles of Agreement. Article
XII states that "the Fund shall have a Board of Governors, an Executive
Board, a Managing Director, and a staff." The highest authority of the
Fund is the Board of Governors, in which each of the member countries
is represented by a Governor and an Alternate Governor. In most cases
the Fund's Governors are either ministers of finance or central bank
governors in their countries. The Board of Governors normally meets
once a year, but it may vote by mail between meetings.
According to the Second Amendment of the Articles of Agreement
which became effective from 1 April 1978, the Board of Governors
may decide to establish a new Council at the ministerial level to
"supervise the management and adaptation of the international monetary system, including the continuing operation of the adjustment
process and developments in global liquidity, and in this connection to
review developments in the transfer of real resources to developing
countries."
The Council, which is intended to be a decision-making body, would
also consider proposals to amend the Articles of Agreement of the
Fund. Pending establishment of the Council, the Board of Governors is
advised in the areas outlined above, by a 21-meniber Interim
Committee on the International Monetary System, established by a
resolution adopted at the 1974 Annual Meetings. In addition, the
Interim Committee advises the Board of Governors "in dealing with
sudden disturbances that might threaten the International Monetary
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System." At the end of 1979, the Fund had 140 members with total
quotas amounting to SDR 39,016.5 million.
The Board of Governors has delegated many of its powers to the Board
of Executive Directors which is "responsible for conducting the business
of the Fund" and is, therefore, in permanent session at the Fund
headquarters in Washington. The Executive Board deals regularly with a
wide variety of administrative and policy matters, issues Annual Reports
to the Board of Governors, conducts discussions to complete the process
of consultations with members, and from time to time produces
comprehensive studies on crucial issues of particular relevance to the
international financial aspects of the economies of Fund members.
There are some Executive Directors. Out of the Executive Directors, six
are appointed (five by the members with the largest quotasthe United
States, the United Kingdom, the Federal Republic of Germany, France,
and Japanand one appointed by Saudi Arabia by virtue of its being
one of the two largest creditor members) and 15 are elected by as many
constituencies, representing the remaining 134 members of the Fund.
The Executive Board selects the Managing Director, who is the
chairman of the Executive Board. In addition, he is chief of the
operating staff of the Fund and conducts, under the direction of the
Executive Board, the ordinary business of the Fund.
Discuss the structure of the IMF operations.
3.2.4 Mode of Operation of IMF

With its capital and reserves held in gold, SDRs and members'
currencies and borrowings raised in the international exchange markets,
the Fund endeavors to eliminate foreign exchange fluctuations and
encourage multilateral trading through its operations. The Fund
Agreement requires that "the par value of the currency of member shall
be expressed in terms of gold as a common denominator or in terms of
the US dollar of the weight and fineness in effect on 1 July 1944." The
par values of members' currencies are expressed in terms of the gold,
SDR and US dollars in a uniform manner with six significant figures,
other than initial zeros.
A member declares the par value of her currency which it cannot alter
beyond 10 per cent without obtaining the Fund's permission. Change in
the initial par value up to 10 per cent can be effected by the member
herself after making her intention known to the Fund and the Fund will
not object to a member changing the initial par value of her currency up
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to 10 per cent. However, changes in the par value of member's currency

beyond 10 per cent cannot be made without prior approval of the Fund.
A member can change the initial par value of her currency only to
correct the fundamental disequilibrium in her balance of payments.
Although fundamental disequilibrium has not been formally defined, a
serious disequilibrium to justify a country's request for devaluation of
her currency in excess of 10 per cent should be evident from a persistent
deficit in her balance of payments. If the Fund has reason to believe that
a member's balance of international payments is caught in the whirlpool
of fundamental disequilibrium, "it shall not object to a proposed change
because of the domestic, social or political policies of the member
proposing the change."
According to the Fund, a stable exchange rate system is essential for
balanced growth of multilateral trade. Consequently, the Fund eliminates fluctuations in the par values of currencies of the members by
helping them in correcting their balance of payments disequilibrium.
When a member country is faced with serious deficit in her external
balance of payments, the Fund sells to it the scarce foreign currency
needed by her to pay her foreign exchange obligations. Thus, the Fund
provides a breathing time to its members during which they should be
able to correct their balance of payments deficit.
However, if the deficit in the balance of payments of a member is due to
some fundamental cause such as overvaluation of her currency or high
cost of domestic production impairing member's capacity to increase her
exports needing structural changes in her economy, the Fund asks the
member to effect the necessary changes. For example, it will ask the
member to take necessary fiscal, monetary and other measures to control
inflation in the economy and raise the labour productivity in order to
effect the required fall in cost-price structure to enable the country to
increase her exports in order to correct her balance of payments deficit.
Where there is conflict between a member's domestic financial policy
over which the Fund has no control and the maintenance of exchange
stability which is one of its major objectives, the Fund mainly relies on
the use of persuasion. In the event of the member persistently indulging
in policies contradictory to Fund's objectives, the Fund can refuse access
to its funds to the member concerned.
A significant change was made in the permissible margin within which
the day-to-day fluctuations in the exchange rate around the par value can
take place. Effective from 18 December 1971 the exchange rates of
members' currencies against their intervention currencies could fluctuate
within wider margins of 22.5 per cent on either side of the parity
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relationship in place of the old narrow margins of 1 per cent on either

side of the par values of the currencies. It means that a member who
maintained the exchange rate for its currency within these margins in
terms of its intervention currency could permit resulting exchange rates
for its currency in relation to currencies other than its intervention
currency to fluctuate within margins of 4.5 per cent from parity, with
further margin of 1 per cent in certain circumstances. This change
replaced the old adjustable by the new crawling peg.
The new provisions in the second amendment Articles of Agreement of
the Fund, provide for flexibility in foreign exchange rates in as much as
money are not bound to establish par values for their currencies; the
margins for exchange transactions based on parity relationships between
currencies for which par values have been established will be wider than
those under the present Articles; and the Fund will have the authority to
change the margins. In addition, a member will be able to abandon a par
value without establishing a new one, unless the Fund decides otherwise
by a high majority of the total voting power.
Upon entry into effect of the Second Amendment from 1 April 1978, all
par values established under the present Articles have ceased to exist for
the purposes of the amended Articles.
While the Fund sells foreign currencies to its members, it purchases
these from those members whose currencies are involved or from those
members who have acquired these currencies through export earnings.
The Fund does not encourage its members to buy foreign currency in
large amount. A member can buy foreign currency from the Fund to tide
over her temporary balance of payments deficit. This amount cannot
exceed the maximum prescribed limit. When a member buys foreign
currency from the Fund, it pays for it in her own currency.
Consequently, the amount of member's currency with the Fund
increases.
The Fund imposes penalty on the member if her currency holdings with
the Fund exceed 25 per cent of her quota. For each subsequent increase
of 25 per cent slab the penalty increases progressively. The Fund sells
currencies to members against their subscriptions for short period which
should not exceed five years' duration to enable the members to tide
over their temporary balance of payments difficulties. A member can
purchase the currency she needs from the Fund not exceeding 25 per
cent of its quota in any one year. The purchases may be increased each
year in the same percentage slab until all amounts to 125 per cent of its
quota.
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Consequently, at the end of five years of continuous purchases the Fund

would hold the maximum amount of currency of the member equaling
200 per cent of its quota; 125 per cent on account of the purchases made
by the member of foreign currency or currencies and 75 per cent being
the share of the original subscription held in member's currency.
Scarcity of currency of a country in foreign exchange market shows a
surplus in the balance of payments of the member country. It implies an
export surplus in the balance of payments of a country. A member with
chronic surplus in her balance of payments is as guiltier of disturbing the
exchange stability as is that member which has chronic deficit in her
balance of payments since both do irreparable damage to the cause of
balanced growth of international trade. The Fund, therefore, asks the
member to remove the surplus in her balance of payments by revaluing
her currency. As soon as the Fund declares a particular currency 'scarce'
the concerned country should revalue her currency so that costs and
prices in the country may increase und her imports may increase and
exports may fall thereby increasing the supply of currency of the
country for the other members.
Discuss the mode of operation of IMF.
3.2.5 Determination of Par Values of Member Countries

Currencies
Under the provisions of Fund, the par values of currencies of members
are expressed in terms of gold, SDR, and the US dollar. Consequently,
in Fund's scheme gold had been retained as a basis of determination of
the par values of members' currencies. Judged from the manner in which
the members transact with the Fund, there appears an analogy between
the gold standard and the Fund plan. Under the Fund scheme, a member
with a deficit in her balance of payments is in a position similar to the
one that was faced by a gold-losing country under the gold standard
while a member with surplus in her balance of payments enjoys a
position analogous to that of a gold-receiving country under the gold
standard. Note that SDR means special drawing rights.
Under the Fund scheme, a member can deal with the Fund "only through
its treasury, central bank, stabilization fund or other similar agency."
The Fund is not a clearing house for all international payments. In fact, a
large chunk of international payments is cleared through the foreign
exchange market without Fund's interference. Transactions made by a
member with the Fund are of an exceptional nature comparable to gold
or short-term capital movements under the gold standard.
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To understand this analogy, let us suppose that faced with a temporary

shortage of the US dollars, Nigeria wants to buy the dollars from the
Fund. As an act of sale of dollars to the Central Bank of Nigeria (CBN)
by the Fund, the CBN will draw against the Fund's dollar account
maintained with the Federal Reserve Bank of New York. Consequently,
the Fund's dollar account with the Federal Reserve Bank of New York
will decrease while the purchase price will be credited to Fund account
maintained with the Central Bank of Nigeria. The Central Bank of
Nigeria will sell acquired dollars to the commercial banks who in turn
will sell them to their customers. This will reduce the deposits of the
commercial banks and consequently their reserves with the CBN too
will be reduced. Thus, the transaction will have a deflationary effect on
the Nigerian economy unless the Central Bank of Nigeria makes
additional cash reserves available or the commercial banks possess
additional cash reserves.
The opposite trend will operate in the US economy. Since the dollars
purchased by Nigeria would be spent to pay for the imports made by
Nigeria from the United States, it would increase the deposits and
reserves of the American commercial banks enabling them to follow an
expansionary policy by expanding credit. Thus transactions with the
Fund influence "bank reserves in precisely the same way as the
movements of gold under the gold standard. It is argued that the
provisions of the Fund with regard to gold are not merely a window
dressing and gold plays an important role "as the Fund's most liquid
asset and as a common anchorage for the members' currency system.
At the instance of the Second Amendment to the Funds Articles of
Agreement, the role of the gold in the international monetary system has
been substantially reduced and in its place SDR has been assigned a
principal place in the new international monetary system.
Consequently, the old controversy about the role of gold in the Fund
scheme has now ceased.
Under the new arrangement, the function of gold as the unit of value of
SDR has been eliminated and its role as common denominator of the par
values of currencies has ended. The official price of gold has been
abolished and members are free to deal in gold in the market and
among themselves. Members are no longer under obligation to make
payments to Fund in gold, nor is Fund any longer required to
make payments to members in gold and the authority of Fund has
been eliminated except under decisions taken by a high majority of 85
per cent of the total voting power.
The Fund is also required to complete the disposition of 50 million
fine ounces of gold, and will decide on the disposal of the remainder of
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its gold holdings (100 million ounces) in various ways by sale on the
basis of market prices or at the official price in effect before the second
amendment.
Under the new arrangement, SDR is the principal reserve asset in the
international monetary system and it has replaced gold as a means of
payment by members to the Fund and by the Fund to members and the
value of currencies held in the General Resources Account of the
General Department is to be maintained in terms of SDRs in accordance
with exchange rates determined for the purpose of transactions in SDRs.
In short, gold has been completely delinked from the Fund.
The value of the SDR is no longer expressed in gold, and the method of
valuation of the SDR is determined by the Fund by a high majority of
the voting power. According to the decision which became effective on
1 July 1978 the SDR is valued in terms of the basket of 16 members'
currencies with weights given to each currency reflecting both its
financial and commercial importance.
Discuss the determination of par values of member countries currencies
by IMF.
3.2.6 Use of International Monetary Fund's Resources

Under the gold standard, whenever a country was faced with deficit in
her external balance of payments, the normal course open to her was to
finance the deficit by using her own official gold reserves before any
corrective measure could operate. If the gold reserves of the country
were inadequate for the purpose, she had to supplement her gold
reserves by short-term external borrowing.
Foreign banks including central banks constituted the principal source of
such short-term credit facilities before the establishment of the Fund.
These foreign banks assisted the countries in financial difficulties by
providing short-term loans with or without the pledge of gold, mostly in
the form of revolving credits. Under gold standard, a country faced with
the balance of payments deficit could acquire foreign exchange by
paying her own currency in exchange. The central banks of the two
countries entered into swap arrangements under which each of the two
central banks made available to its counterpart at the other end its own
currency and that other (purchaser) bank paid for it by crediting the
account of the creditor (seller) bank in its own currency.
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The country involved could also raise funds to finance the temporary
deficit in her balance of payments through the sale of bills of exchange
in local currency with the condition that the countrys government
would repurchase such bills at the unchanged foreign rate after a short
period, usually 91 days. The central bank of the country concerned
usually serves as the channel through which such transactions takes
place. Irrespective of the form of the arrangement, the credit-worthiness
of the debtor was the most important consideration in determining the
rate of interest, the duration and the amount of the loan which could be
made available to the country.
The establishment of the Fund has made an important addition to the
existing institutional arrangements for the borrowing of short-term
funds. The Fund is an important source of supply of international
liquidity, both conditional and unconditional. The terms and conditions
on which credit can be made available to a member from the Fund and
the total loan that can be given to a member are laid down in the Funds
Articles of Agreement.
For instance, the borrowing member must have paid her subscription,
must have declared the par value of her currency and cannot borrow
more than 25 per cent of her quota during a 12-month period and her
total borrowing should not exceed 125 per cent of its quota. The Fund
grants loans of foreign currencies to members to correct the temporary
deficit in their balance of payments which is likely to be removed at the
earliest possible period. For example, a countrys external balance of
payments position may become adverse due to heavy imports of foodgrains due to severe famine. This deficit is of a temporary nature as it
would disappear after one or two years when the new harvest in the
coming years puts the countrys balance of payments in order. The Fund
helps the member in such a case.
Nevertheless, if the deficit in the balance of payments of a member
country is due to certain permanent and persistent cause, such as
overvaluation of the currency of the member, the Fund does not help the
member in correcting the deficit in her balance of payments. Instead it
advices her to bring the external value of her currency into conformity
with the par values of currencies of other members by affecting
necessary devaluation of her currency.
Discuss the modality for the use of International Monetary Fund's
resources in helping member countries.
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4.0
MACRO-ECONOMICS
CONCLUSION
From the foregoing analysis, you can understand the modality and
reasons for the establishment of both the World Bank and the
International Monetary Fund. You can also understand the lending
operations of both financial institutions towards helping the economic
development of member countries as well as bailing them out of balance
of payment problems. Lastly you can also understand the means through
which the par values of the member countries currencies are determined
by the IMF.
5.0
SUMMARY
This study unit has been used to discuss the origin and nature of
operations of both the World Bank and the International Monetary Fund.
In this unit, discussion is also devoted to the reasons for the existence of
the two international financial institutions. The unit is also used to
discuss the functions of World Bank and IMF to the member countries
in the areas of economic development and ameliorating their balance of
payment problems.
The next study unit is used to discuss international economic
institutions.
6.0
What are the functions of the World Bank to the member countries?
Identify and explain the reasons for the establishment of IMF.
7.0

Edition. Berkshire, England: Maindenhead.
House Pvt Limited.
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UNIT 4
MACRO-ECONOMICS
INTERNATIONAL ECONOMIC INSTITUTIONS
CONTENTS
1.0
2.0
3.0
4.0
5.0
6.0
7.0
Introduction
Objectives
Main Content
3.1 General Agreement on Tariffs and Trade (GATT)
3.1.1 Origin of General Agreement on Tariffs and Trade
3.1.2 Membership of General Agreement on Tariffs and
Trade
3.1.3 Purpose of General Agreement on Tariffs and
Trade
3.1.4 GATT and Tariff Redactions
3.1.5 Defects and Future of GATT
3.2
United. Nations Conference on Trade and Development
(UNCTAD)
3.2.1 Origin of UNCTAD
3.2.2 Functions of UNCTAD
3.2.3 Directive Principles of UNCTAD
Conclusion
Summary
1.0
INTRODUCTION
In the previous study unit, you have been exposed to the international
financial institutions established after the World War II. In this study
unit, some international economic institutions which were established at
the same time with those financial institutions are discussed. Such
international economic institutions include the General Agreement on
Tariffs and Trade (GATT) and the United Nations Conference on Trade
and Development (UNCTAD).
2.0
OBJECTIVES
mention the reasons for the establishment of GATT

identify the reasons for the establishment of UNCTAD
mention and explain the defects inherent in operations of GATT
discuss the functions of UNCTAD.
3.1
General Agreement on Tariffs and Trade (GATT)
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3.1.1 Origin of General Agreement on Tariffs and Trade

The General Agreement on Tariffs and Trade (GATT) was negotiated in
1947. The 23 countries which originally signed it were at the time
engaged in drawing up the charter for a proposed International Trade
Organization (ITO) which would have been a United Nations
specialized agency. The GATT was based largely on selected parts of
the draft ITO charter with the purpose of liberalizing trade.
GATT was provided with the minimum institutional arrangements
because it was expected that the responsibility would soon be taken over
by the proposed ITO. However, plans for the ITO had to be abandoned
when it became clear that its charter would not be ratified.
Consequently, the GATT was left as the only international instrument
for laying down the trade rules accepted by nations responsible for bulk
of the world trade.
The highest body of GATT is the Session of Contracting Parties which
is usually held annually. GATT decisions are generally arrived at by
consensus and not by vote and when on rare occasions voting takes
place each contracting party (member country) has only one vote. Most
decisions by vote are taken by simple majority, but a two-thirds majority
of votes cast, with the majority comprising of more than half the
member countries, is needed for "waivers" authorizations in particular
cases, and to depart from specific obligations under the Agreement.
Trace the origin of GATT.
3.1.2 Membership of General Agreement on Tariffs and Trade

The membership of GATT has increased from 23 contracting parties at
the time it was negotiated in 1947 to 84 contracting parties on 24
November 1979 drawn from different parts of the world. In addition to
84 member countries, 3 countries had acceded provisionally while the
number of countries to whose territories the GATT has been applied and
which now, as independent states, maintain a de facto application of the
GATT pending final decisions as to their future commercial policy stand
at 30. Thus, about 117 countries are currently applying the rules of
GATT in their international trade.
GATT, which entered into force in January 1948, is a multilateral treaty
subscribed to by 84 countries which together account for about 90 per
cent of world trade. It is the only multilateral instrument that lays down
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agreed rules for international trade. Since its inception, GATT has also
functioned as the principal international body concerned with
negotiating the reduction of trade barriers and with international trade
relations.
GATT is thus both a code of rules and a forum in which countries can
discuss and solve their trade problems and negotiate to enlarge world
trading opportunities. The uninterrupted flow and tremendous growth in
the volume of international trade over the years has provided continuing
evidence of GATTs success in its double role. GATT rules govern the
trade of its member countries and the conduct of their trade relations
with one another.
3.1.3 Purpose of General Agreement on Tariffs and Trade

Over the years, GATT in the international economic scene has evolved
considerably, and its activities have been greatly influenced by the
major developments that have taken place. These developments include
changes in the relative strengths of important countries or groupings of
countries, the emergence of the developing countries as a major factor in
international affairs, the trend toward economic groupings, and the
growing interest of Eastern European countries in the GATT.
The trade problems of the developing countries and their solution have
become a progressively increasing pre-occupation of GATT. The
growing international awareness in the early nineteen-sixties of the
relevance of trade to the problems of the developing countries and the
increasing attention and resources devoted to this aspect of the
development problem stemmed in no small part from the work done by
GATT. The developing member countries of GATT have been able to
apply some of GATTs provisions.
Recently, GATT has increasingly focused its attention on the trade
interests of developing countries and the promotion of these interests has
been an important element in the multilateral trade negotiations which
have been the principal focus of GATT's work ever since the "Tokyo
Round" of multilateral trade negotiations was held in September 1973.
The Tokyo Declaration that was passed at a Ministerial meeting held in
Tokyo in September 1973 is a document embodying the agreement to
open the new round of trade negotiations, more ambitious in scope than
any ever previously attempted.
The Declaration also provides for the possibility of improvements in the
framework and procedures of GATT itself. While developed countries
are expected to negotiate on a basis of reciprocity, that is, to make trade
concessions balancing those that they receive, they do not expect from
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the developing countries contributions that are inconsistent with their

individual financial, trade and development needs. Under the provisions
of the Tokyo Declaration, a Trade Negotiations Committee guides the
negotiations. It consists of the representatives of all the countries
engaged in the negotiations. These countries, numbering 99, account
together for more than nine-tenth of world exports.
Discuss the purpose for the establishment of GATT.
3.1.4 GATT and Tariff Redactions

As you have already observed, GATT is an international forum for
discus-and negotiations on trade. Its principal purpose is to effect
substantial reduction in tariffs and other barriers to trade. The GATT
has been able to achieve this objective through long series of
negotiations.
The most ambitious of these negotiations opened in September 1973 by
a Ministerial meeting in Tokyo which was attended by 102 countries.
There are other seven major trade negotiations which took place under
its auspices in 1947 (in 'Geneva), in 1949 (in Annecy, France), in 1951
(in Torquay, England), in 1956 (in Geneva), in 1960-61 (in Geneva, the
"Dillon Round"), in 1964-67 in (Geneva, the "Kennedy Round") and the
"Tokyo Round" held in Tokyo in 1973, among others.
In addition to these major trade negotiations, smaller-scale negotiations
have preceded the accession to GATT of individual countries such as
Japan, Switzerland and Hungary. As a result, the tariff rates for
thousands of items entering into world trade have been either reduced or
bound against increase. The Kennedy Round of trade negotiations alone
reduced the average level of world industrial tariffs by about one-third.
The concessions agreed upon in these trade negotiations have affected a
high proportion of the total world trade of GATT countries, and
indirectly, the trade of many non-members as well. GATT has thus
contributed greatly to the spectacular growth of world trade since 1948.
Discuss the role played by GATT in tariff reduction since its inception.
3.1.5 Defects and Future of GATT

While GATT undoubtedly provides a useful forum for holding
multilateral negotiations on reciprocity basis and also provides
machinery for discussing and settling disputes, it is nothing more than a
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code of behavior. Although the Kennedy Round marks the most

spectacular achievement of GATT, yet it is merely an improvement. The
GATT has no super national authority and protection has been justified
by taking recourse to various escape clauses. Due to the diverse nature
of GATT membership, uniform general rules are difficult to frame and
political and economic motives are frequently entangled.
The combination of the principle of non-discrimination with the
principle of reciprocity causes pertinent biases and formidable problems.
Furthermore, since the negotiations take place on commodity to
commodity basis, there is a bias in favour of trade with each other as
against trade with third parties
Although in principle GATT recognizes that multilateral trading is
better than bilateralism yet in practice the principle of reciprocity places
a premium on bilateralism. Thus there is need to reconcile the nondiscriminatory multilateral trading with the principle of reciprocity.
Moreover, it is necessary to provide new opportunities for all countries
to expand their trade by reducing tariff and non-tariff restrictions that
now hamper exchanges of industrial and agricultural products.
And in doing so, not only GATT declaration but economic necessity and
social justice require that additional trade benefits be made available to
the developing countries. The GATT is not a representative world body
as it excludes important countries of the communist block and also
excludes some newly independent developing nations. It has been called
the "rich countries' club" by the developing countries. According to
these countries, GATT has mostly served the interests of the United
States and other developed countries of Europe.
In those products which are of special interest for developing countries,
GATT rules do not apply. For example, trade in cotton textiles is
regulated under a special arrangement which came into force in 1962.
Under this arrangement, the developing countries are requested to
impose voluntary quotas on their exports when some importing country
feels that it is threatened by imports from cheaper world sources.
Judging from the totality of its working, it can be said that GATT has
proved its case by playing an important role in reducing the tariffs and
other barriers to trade. "It has succeeded in surviving the post-war period
of general balance of payments difficulties without surrendering the
principle that such restrictions were to be allowed only as exceptions to
general rule which itself should be applied as soon as circumstances
permitted.
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If present is any guide for the future, the GATT has a bright future
assured for it. As long as the money and trade policies of world
countries fall short of the idea of free trade, there will remain the
necessity for the sincere and successful efforts of GATT.
Identify the defects inherent in the operations of GATT.
3.2
United Nations Conference on Trade and Development

(UNCTAD)
3.2.1 Origin of UNCTAD

Among numerous institutions which have been created under the banner
of the United Nations Organization is the United Nations Conference on
Trade and Development, popularly known as UNCTAD. The
international economic institution came into being as a result of the UN
resolution on 'Development Decade' of 1961. This organization is a
forum of nations for finding and resolving the various international
knotty problems of trade and development.
The Cairo Conference of the developing countries held in July 1962 on
the problem of economic development passed the 'Cairo Declaration of
Developing Countries' calling for the convening of the United Nations
Conference on Trade and Development and constituting an
"International Trade Organization" (ITO) which would consider vital
questions relating to the international trade of the poorer nations.
The United Nations Economic and Social Council agreed to convene
such a conferencethe first UNCTADand passed Resolution on 3
August 1962 which was endorsed by the United Nations General
Assembly in its Resolution of 8 December 1962. The historic decision
of the United Nations General Assembly to name 1960-69 as a 'Development Decade' was a further recognition of the deep world-wide
concern with the urgent necessity raising the living standards of the
peoples of the developing countries. All these developments led to the
convening of the United Nations Conference on Trade and Development
in Geneva from March to June 1964.
In July 1963, the United Nations Economic and Social Council passed a
resolution for UNCTAD to be convened at an interval of not more than
three years. The United Nations General Assembly accepted the
recommendation and UNCTAD was established as a permanent organ
of the UN General Assembly. The UN General Assembly also defined
the functions, activities and membership of UNCTAD.
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UNCTAD has set up a Trade and Development Board as a policy

making body to take policy making decisions when the Conference is
not in session. The Board is composed of 55 members elected on the
basis of equitable geographical distribution. The Board is also helped by
subsidiary committees which deal with the problems of primary
products, manufactured and semi-manufactured goods, development
finance and questions relating to invisible services, including shipping
and insurance, etc.
Discuss the origin of UNCTAD.
3.2.2 Functions of UNCTAD

The main purpose of creating UNCTAD was to gear up speedy
development of the underdeveloped countries by solving the problems
of the sluggish expansion of their export trade, deficits in their external
balance of payments and excessive burden of foreign debt, etc.
The specific functions of UNCTAD including the following:
1.
to promote international trade, especially with a view to accelerating the economic development of the underdeveloped
countries, particularly trade between countries with different
systems of economic and social organization taking into account
the functions performed by the existing international
organizations.
2.
to formulate the principles and policies of international trade and

related problems of economic development.
3.
to make proposals for putting the said principles and policies into
effect and to take such other steps within its competence as may
be relevant to this end.
4.
generally, to review and facilitate the coordination of activities of

other institutions within the United Nations system in the field of
international trade and related problems of economic
development and in this regard to cooperate with the General
Assembly and the Economic and Social Council in respect of the
performance of their chartered responsibilities.
5.
to be available as a centre for harmonizing the trade, related

development policies of governments and regional economic
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groupings in pursuance of Article 7 of the United Nations

Charter.
Mention the functions of UNCTAD.
3.2.3 Directive Principles of UNCTAD

The first UNCTAD was held in Geneva from 23 March to 16 June 1964.
The conference was attended by delegates from 120 countries, 13
specialized agencies, and 32 non-government bodies. The aim of the
conference was to provide means of international cooperation and to
find appropriate solution to the problems of world trade in the interest of
the whole world and particularly recognizing the urgent needs of the
developing countries.
For the above purpose the conference laid down a number of principles,
policies and recommendations to bring about basic changes in the
working and set-up of trade relations between the advanced and poor
nations.
The following were the important directive principles laid down and
accepted by the Conference:
1. Economic development and social progress should be the common
concern of the whole international community for which peaceful
relations and cooperation should be sought.
2. National and international economic policies should be directed
towards the attainment of the division of labour consistent with the
needs and interests of the developing countries in particular, and the
world as a whole in general.
3. Developing countries should reduce restrictions on trade that hinder
the trade of the underdeveloped countries and should increase the
markets for the products of developing nations.
4. Developed countries should extend new preferential concessions,
both tariff and non-tariff to developing countries also. These should
not be limited to developed countries only.
5. Assistance and aid from the developed countries should not be
principles of equality and non-interference in their internal affairs.
No distinction should be made on the basis of economic systems. It
was decided to hold a periodic meeting of UNCTAD after every
three years. The Trade and Development Board was authorized to
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take policy making decisions when the conference was not in

session.
There were other conferences held after the above. The above
conference has been discussed herein in order to throw some light into
the operations of the institution.
Mention the directive principles as enunciated by the UNCTAD I
Conference.
4.0
CONCLUSION
From the foregoing analysis, you can understand the origin and purpose
of both the GATT and UNCTAD in the world trade and economic
development. You can also understand the nature of the membership of
GATT. In addition, you are now in a position to discuss the role played
by GATT in the reduction of tariff and the defects inherent in the
operation of the institution. Lastly, from the analysis, you can also
understand the nature, functions and the directive principles of
UNCTAD.
5.0
SUMMARY
This unit has been used to discuss the origin of both GATT and
UNCTAD. Furthermore, the unit has also been used to discuss the
purpose, functions and defects inherent in the operations of GATT. The
functions and directive principles involved in the operational activities
of NCTAD have also been discussed in this unit. The next unit discusses
monetary policy.
6.0
10)
11)
Mention and explain the functions of GATT.

Identify and discuss the functions of UNCTAD.
7.0

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UNIT 5
MACRO-ECONOMICS
MONETARY POLICY
CONTENTS
1.0
2.0
3.0
4.0
5.0
6.0
7.0
Introduction
Objectives
Main Content
3.1
Meaning of Monetary Policy
3.2
Objectives of Monetary Policy
3.3
Instruments of Monetary Policy
3.3.1 Open Market Operation
3.3.2 Bank Rediscount Rate
3.3.3 Liquidity Reserve Ratio
3.3.4 Selective Credit Control
3.3.5 Special Directives
3.3.6 Minimum Cash Ratio
3.3.7 Moral Suasion
3.3.8 Exchange Control
Conclusion
Summary
1.0 INTRODUCTION
The monetary policy is one of the stabilisation policies normally
employed by the government to manage the economy. In essence,
monetary policy is one of the stabilisation measures which the
government employs to check economic fluctuations in any economy.
The monetary policy is used in conjunction with the fiscal policy, by the
government, to check macroeconomic problems such as inflation,
unemployment, low level of aggregate consumption and production by
suing taxes and expenditure.
Monetary policy is the subject of discussion in this unit. The policy is
discussed in relation to its meaning, objectives of the policy and the
major instruments employed by the government in implementing its
objectives.
2.0
OBJECTIVES
86
explain the meaning of monetary policy

identify and discuss the objectives of monetary policy
mention and explain the instruments of monetary policy.
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3.0
MAIN CONTENT
3.1
Meaning of Monetary Policy
MACRO-ECONOMICS
Monetary policy involves the manipulation of some monetary variables

by the central bank to regulate the supply and demand for money in the
economy.
In essence, monetary policy refers to the use of monetary variables such
as the interest rate regime, credit rationing, directives on credits, and
total money supply or quantity of money in circulation to regulate the
economy.
In the modern time, monetary policy is not only being used to regulate
money supply in the economy. The scope of its use has been extended to
cover issues such as external monetary relations in the area of imports
restriction regarding demand and consumption of foreign goods.
For instance, when the imported goods are becoming very expensive,
the monetary authorities may deem it fit to control their demands and
consumption through the contraction of credits in order to reduce access
to cheap money for affording them.
Also since inflationary and deflationary trends can result in arbitrary
redistribution of income, monetary policy can be employed to control
such macroeconomic problems in order to maintain stable level of
prices.
Explain the term monetary policy.
3.2
Objectives of Monetary Policy
The major objectives for the use of monetary policy, just like the fiscal
policy, include the following:
1.
Maintaining Price Stability
This is achieved by keeping inflationary trend in check in the economy.

Inflation can arise as a result of excess supply of money in the economy,
which can be checked by contracting money supply or reducing money
in circulation.
The reduction in the quantity of money in circulation has the effect of
depleting the income available to the consumers, thus reducing their
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disposable income and the quantity of goods that they can afford to
purchase. This has the overall effect of checking inflation in the
economy and thus the general price level is curtailed from rising.
Since monetary policy can be employed to control inflationary and
deflationary trends, as you have observed in the foregoing discussion, by
implication it can be employed to maintain stable level of prices in the
economy.
2.
Maintaining Full Employment
This implies the reduction of the level of unemployment in the

economy. This can be achieved through credit expansion during a
depressed state in the economy. The availability of cheap money to the
investors affords them to expand their business operations and also
establish new ones through diversification of operations.
The expansion in business operations and increased investment make
possible the employment of idle resources including labour which are
unemployed as a result of the depressed state of the economy.
3.
Stimulate Economic Growth and Development
The reduction in the level of unemployment in the economy implies the

engagement of the idle labour which can be used to stimulate economic
growth and development.
The credit expansion instituted to stem the tide to the depressed state of
the economy through availability of cheap money to the investors
affords them the opportunity to expand their business operations and
also establish new ones as a result of diversification of operations.
The expansion in business operations and increased investment make
possible the employment of all categories of idle resources which are
unemployed as a result of the depressed state of the economy, serves as
potential catalyst for economic growth and development.
4.
Maintaining Favourable Balance of Payments Position
You have observed from the explanation of the nature of monetary

policy that the scope of its use has been extended to cover issues such as
external monetary relations in the area of imports restriction regarding
demand and consumption of foreign goods.
Since it can be used to curtail the importation and consumption of
expensive and luxury goods through the contraction of credits in order
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to reduce access to cheap money for affording them, monetary policy

can be employed to maintain a favourable balance of payments position
for the economy.
5.
Maintaining Stability in External Value of Countrys

Currency
You have observed from preceding discussion that contraction of credits

can lead to the curtailment of the access to cheap money for purchasing
imported goods, which can be expensive and luxury in nature. Monetary
policy, therefore, can be employed to maintain a favourable balance of
payments position for the economy.
Furthermore, contraction of credits available for consumer goods,
particularly the imported goods, can lead to the enhancement of the
survival of the infant industries. It can also encourage the establishment
of import substitution industries in the economy. This will conserve the
countrys foreign exchange earnings, and hence spells a favourable
balance payments position for the economy.
List and discuss the various objectives which the monetary policy can be
used to achieve in the economy.
3.3
Instruments of Monetary Policy
There are some instruments which are normally employed by the

monetary authorities such as the Central Bank of Nigeria and Federal
Ministry of Finance for implementing monetary policy. Such
instruments include the following:
3.3.1 Open Market Operation

The open market operation thrives on the sale and purchase of
government securities such as treasury bills, treasury certificates, and
government bonds, among others.
The transactions are carried out by the central bank on periodic basis.
This depends on the state of the economy. For instance, the Central
Bank of Nigeria can sell government securities such as bonds to mop up
excess liquidity occasioned by the period of economic expansion. The
sale of government securities by the apex bank results in monetary
contraction.
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The sale of the government securities results in depressing their price

and thereby occasion withdrawal of money from the public. It is
mandatory for the commercial banks to purchase government securities.
Hence, as these securities are purchased by the commercial banks
through the transfer of bank deposits to the central bank, it reduces the
capacity of the banks to create credits.
In corollary, during the period of depression (economic contraction) the
central bank buys back government securities to release more money
into the economy through the commercial banks. Hence, as government
securities are sold by the central bank through the transfer of bank
deposits back to them from the central bank; it reduces the capacity of
the commercial banks to create credits.
You will understand from this analysis that the buying and selling of
treasury bills, treasury certificates and other government securities
regulates the cash liquidity of the commercial banks with which to
create credits in the economy.
3.3.2 Bank Rediscount Rate

The bank rediscount rate is the rate of interest at which the central bank
lends money to the commercial banks. This bank rate is normally varied
from time to time in order to use it to regulate the supply of money in
the economy.
The Central Bank of Nigeria introduced the monetary policy rate in
December 2006 to replace the minimum rediscount rate in Nigeria. The
implication is that the MPR as the level at which banks obtain credit
from the apex bank. The rate is usually adjusted periodically to maintain
overall macroeconomic stability in terms of regulating money supply in
the economy.
In order to reduce money in circulation, the apex bank will raise the rate,
which will result in raising the cost of borrowing from the bank. It has
concomitant effect of raising the rate of interest for private sector
borrowing. This discourages corporate bodies and prospective investors
from borrowing from the commercial banks. Hence, the flow of funds to
the private sector in the economy is curtailed.
In the period of depressed economy, the rediscount rate is lowered to
encourage the commercial banks to borrow from the apex bank which
enhances their credit creation capacity. The implication is that corporate
bodies and prospective investors are encouraged to borrow from the
commercial banks. Hence, the flow of funds to the private sector in the
economy is expanded.
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3.3.3 Liquidity Reserve Ratio

This is applicable to regulation of the liquid cash with the commercial
banks with a view to vary their credit creation capacity. During the
period of inflation or excess liquidity in the economy, the apex bank will
increase the ratio of the commercial banks demand and time deposits
held with it to reduce the quantity of money in circulation.
In corollary, during the period of deflation or illiquidity in the economy,
the apex bank will decrease the ratio of the commercial banks demand
and time deposits held with it to increase the quantity of money in
circulation.
3.3.4 Selective Credit Control

This measure is used by the central bank to direct the credit flows of
commercial banks to particular sectors of the economy with a cautionary
note that such directive does not affect the total credit in the economy. It
is also used with the intention to change the composition of credit from
undesirable trend to a desirable pattern that ensures meaningful
economic growth and development.
The examples of such favoured sectors of the economy in Nigeria are
agriculture, solid minerals, transport, power and infrastructure,
generally, which have occupied a front burner in the countrys economic
policies in the quest to use them to diverse the economy and enhance the
countrys economic growth and development.
3.3.5 Special Directives

The apex bank also has the statutory authority to instruct commercial
banks to increase their loan portfolio beyond what they consider
adequate, to certain areas of economic activities in the economy.
For instance, the central bank can instruct commercial banks to increase
their loan portfolio to the sectors which the government considers to be
strategic to the economic growth and development of the country.
Examples of such sectors in the country are agriculture, solid minerals,
transport, and power.
3.3.6 Minimum Cash Ratio

The cash ratio is the minimum proportion of cash deposits that the
commercial banks must maintain with apex bank for daily commitment
in terms of meeting customers demand.
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The central bank alters the ratio on periodic basis in order to regulate the
supply of money in the economy. The ratio is raised when the apex bank
desires to curtail credit expansion by the commercial banks. On the
other hand, the ratio is reduced when the apex bank desires to encourage
credit expansion by the commercial banks.
3.3.7 Moral Suasion

This is a subtle means of controlling the commercial banks in terms of
encouraging them to favour some selected sectors of the economy in the
process of extending credit facilities to the private sector.
As you have observed from the preceding discussion, the favoured
sectors of the economy in Nigeria are agriculture, solid minerals,
transport, power and infrastructure generally. The Governor of the
Central Bank of Nigeria, during the Annual Bankers Committee
Meeting, is expected to persuade the chief executives of commercial
banks to give preferential consideration to such sectors of the economy.
3.3.8 Exchange Control

It has been argued that exchange control by various countries in the
West Africa sub-region is necessitated by persistent deficits in their
foreign accounts. Hence they are compelled to introduce tight exchange
controls over the limited foreign exchange earnings, which is the
responsibility of their respective apex banks.
For example, the Central Bank of Nigeria supervises foreign exchange
transactions in the country, and it has introduced some measures to
curtail its use over the years. The pre-1986 period witnessed tight
control on the usage of foreign exchange by individuals and private
sector organisations. The introduction of SAP in the late 1986 brought
about transactions on foreign exchange with strict supervision by the
apex bank.
The apex bank also intervenes occasionally to guide against abuse in the
foreign exchange market so as to maintain stability in the external value
of the countrys currency.
List and explain the various instruments with which monetary policy can
be implemented in the economy.
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4.0
MACRO-ECONOMICS
CONCLUSION
From above analysis, you can understand the meaning of monetary

policy and the significance of its use in any economy. You can also
understand the fundamental objectives for which the monetary policy is
instituted to achieve in using it. Furthermore, you are exposed to the
instruments which are amenable for use in pursuing and achieving the
objectives of monetary policy.
5.0
SUMMARY
This unit has been used to discuss the nature of monetary policy, its
fundamental objectives and the instruments which are normally
employed by the appropriate authorities to implement the monetary
policy objectives towards tackling macroeconomic problems in any
country. The next study unit is used to discuss fiscal policy; the Siamese
twin of the monetary policy.
6.0
Mention and discuss the fundamental instruments which can be used to

pursue and achieve the objectives of monetary policy.
7.0
Lipsey, R. G. and K. A. Crystal (1997). An Introduction to Positive

Dwivedi, D.N (1987). Managerial Economics. New Delhi: Vikas
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MODULE 3
Unit 1
Unit 2
Unit 3
Unit 4
Unit 5
Fiscal Policy
Unemployment
Demand and Supply of Money
Financial Institutions
Balance of Trade and Balance of Payments
UNIT 1
FISCAL POLICY
CONTENTS
1.0
2.0
3.0
4.0
5.0
6.0
7.0
Introduction
Objectives
Main Content
3.1
Meaning of Fiscal Policy
3.2
Objectives of Fiscal Policy
3.3
Instruments of Fiscal Policy
3.3.1 Taxation
3.3.2 Public Expenditure
3.3.3 Public Budget
Conclusion
Summary
1.0
INTRODUCTION
In the last unit, monetary policy as one of the stabilisation measures

which the government employs to check economic fluctuations in the
economy is discussed. Another form of such stabilisation measures is
the fiscal policy, which is the subject of our discussion in this unit.
Fiscal policy is used by the government to check macroeconomic
problems such as inflation, unemployment, low level of aggregate
consumption and production by suing taxes and expenditure.
In this unit, therefore, fiscal policy as a macroeconomic measure is
discussed so that you will become conversant with such stabilisation
policy in terms of the use of taxes and government expenditure to tackle
above macroeconomic problems.
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2.0
MACRO-ECONOMICS
OBJECTIVES
explain the meaning of fiscal policy

identify and discuss the objectives of fiscal policy
explain the tools of fiscal policy.
3.1
Meaning of Fiscal Policy
Fiscal policy refers to the use of taxation and government expenditure to

check some economic adversities such as inflation, unemployment, low
level of aggregate consumption and production by the government with
the help of government agencies such as the Finance Ministry, the
Budget Office, Federal Inland Revenue Service, etc.
In other words, fiscal policy is normally employed by the government to
pursue and achieve some macroeconomic objectives in terms of
checking economic problems such inflation, unemployment, low level
of aggregate consumption and production.
Basically, therefore, fiscal policy is employed by the government to
prop up aggregate production and consumption in the economy in order
to tackle major macroeconomic problems which border on inflation and
unemployment.
Hence, fiscal policy is used in complementary stance with the monetary
policy towards pursuing and achieving fundamental economic
objectives such as attainment of full employment, maintaining stability
in price level, and desirable balance of payment position, among others.
The overall purpose for the use of fiscal policy is the attainment of
desirable level of economic growth and development.
Discuss the term fiscal policy.
3.2
Objectives of Fiscal Policy
The fundamental objectives for the use of fiscal policy include the
following:
1.
Control of Inflation
A major macroeconomic problem of inflation is normally tackled with

the use of fiscal policy, in addition to the use of the monetary policy as
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you have observed in the preceding unit. Inflation can arise as a result of
excess supply of money in the economy, which can be tackled with the
use of increased taxation on the income of the consumers, thus reducing
their disposable income.
The returns on investment (or operational incomes) of the corporate
organisations can also attract lower level of taxation with the intent of
encouraging them to expand their productive capacity. The effect
translates in increased level of production and more employment of
labour, which tends to reduce the level of unemployment.
2.
Increase in Employment Opportunities
The fiscal policy is also aimed at creating more employment

opportunities in the economy. This can be achieved with the use of
government expenditure, which can be directed at propping up the level
of production in terms of production expansion to accommodate idle
labour resources.
3.
Promotion of Economic Stability
Fiscal policy can be used to ensure economic stability by employing

import and export duties, which are forms of taxation on imported and
exported goods.
The use of fiscal policy is very crucial in the face of economic
fluctuations as a result of the cyclical nature of economic cycle. Moreso,
most economies of the world are exposed to external economic
fluctuations given the fact that they operate within a global economy.
Hence, to counter the undesirable effects of globalisation, the less
developed countries are compelled to use fiscal policy in checking
external economic fluctuations.
For instance, higher import duties can be used to check the importation
and consumption of luxury goods. Therefore, the use of higher import
duties can result in curbing reckless spending by the consumers, and
thus checking imported inflation.
4.
Increase in Rate of Investment
Fiscal policy can also be used to enhance the rate of investment in a

given economy. This can be achieved by granting tax waivers by the
government or the granting of tax holiday for pioneer status for
emerging and infant industries.
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The use of lower tax rate on consumer incomes can serve as a potent
means of encouraging increase in aggregate consumption in the
economy and thus enhancing investment expansion by the existing
industries, and attracting foreign direct investment into the economy.
5.
Redistribution of National Income
The fiscal policy can be used to redistribute the national income among
the citizens in an economy. This is aimed at ensuring that extreme
income and wealth inequalities are reduced or totally obliterated in the
economy.
The use of progressive taxation structure can ensure redistribution of
national income among the citizens by increasing the real income of the
middle and lower incomer earners while reducing the incomes of the
upper class in the economy.
The tax regime can also be extended to cover personal wealth of
individuals, expenditure, real estate, and consumption of luxury goods
and services, among others. The effect is reducing incomes of the
wealthy individuals while increasing incomes of the lower and middle
class in the economy.
Mention and discuss the various objectives of fiscal policy.
3.3
Instruments of Fiscal Policy
The tools normally employed by the government in the use of fiscal

policy include the following:
3.3.1 Taxation
Taxation refers to the compulsory levy imposed on the people and
corporate bodies and other businesses operating in an economy. The
compulsory levy is imposed on the incomes, real estate, goods, services,
and business transactions.
Taxes can be direct or indirect. Taxation is regarded as direct when
imposed on the incomes of individuals, corporate bodies and other
businesses. It is regarded as indirect tax when it is imposed on goods
and services consumed by the people in the economy.
Taxation is regarded as the most effective tool of fiscal policy because it
can be used to achieve the following objectives.
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i)
ii)
iii)
iv)
v)
vi)
vii)
viii)
ix)
x)
MACRO-ECONOMICS
To check conspicuous consumption.

Redirect investment from consumer goods to capital goods.
To encourage saving and investment.
To redistribute incomes and thus reduce economic inequalities.
Increase government revenue earnings in the economy.
To enable the government develop infrastructure.
Make possible the mobilisation of economic surpluses.
To help curb unemployment through lower company taxation and
tax relief.
To develop infant industries through higher import duties.
To redirect investment into neglected areas of the economy.
Hence, the government manipulates taxation to pursue and achieve

fiscal policy objectives; either raising or reducing tax incidence on
individuals and corporate organisations in the economy.
3.3.2 Public Expenditure

This refers to the government expenditure which is expended on the
development of both economic and social infrastructure. In practice,
government spending is either increased or decreased to tackle
macroeconomic problems such as unemployment, inflation, low level of
aggregate consumption and production in the economy, among others.
The government expenditure, therefore, is strategic towards ensuring
enhanced growth rate in the economy, creating more employment
opportunities, raising aggregate income, and reducing income
inequalities, among others.
3.3.3 Public Budget

This refers to the financial plan of the government which is based on
estimated (or projected) revenue and expected expenditure in a fiscal
year. The government budget can be surplus or deficit.
The government budget is regarded surplus when the projected income
for the fiscal year exceeds the estimate expenditure for the same period.
The public budget is said to be deficit when the projected income for the
fiscal year is less than the estimate expenditure for the same period.
The surplus budget is used when there is too much money in circulation
in the economy, which is an invitation to inflation. The deficit budget is
used when the economy is in a depressed state. A balanced budget is
achieved when the economy is in equilibrium, which is a state of neither
inflationary nor deflationary.
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4.0
MACRO-ECONOMICS
CONCLUSION
From the foregoing analysis, you can understand the meaning of fiscal
policy and the essence for its use in any economy. You can also
understand the fundamental objectives for which the fiscal policy is
instituted to achieve in the economy. Furthermore, you are exposed to
the tools which are amenable for use in pursuing and achieving the
objectives of the fiscal policy.
5.0
SUMMARY
This study unit has been used to discuss the nature of fiscal policy, its
fundamental objectives and the tools which are normally employed by
the government to implement the fiscal policy objectives towards
tackling macroeconomic problems in the economy.
6.0
Mention and discuss the fundamental tools which can be used to pursue
and achieve the objectives of fiscal policy.
7.0
Lipsey, R. G. and K. A. Crystal (1997). An Introduction to Positive

Lipsey, R. G. et al (1987). Economics. London: Harper and Row
Publishers.
Dwivedi, D.N (1987). Managerial Economics. New Delhi: Vikas
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UNIT 2
UNEMPLOYMENT
CONTENTS
1.0
2.0
3.0
4.0
5.0
6.0
7.0
Introduction
Objectives
Main Content
3.1
Nature of Unemployment
3.2
Meaning of Unemployment
3.3
Types of Unemployment
3.4
The Private and Social Cost of Unemployment
3.4.1 The Private Cost of Unemployment
3.4.2 The Social Cost of Unemployment
Conclusion
Summary
1.0
INTRODUCTION
Basically, the labour force comprises all those people holding a job or
registered as being willing and available for work. The unemployment
rate refers to the percentage of the labour force without a job but
registered as willing and available for work.
Nonetheless, some people without a job are really looking for work but
have not bothered to register as unemployed. These people are not
normally included in the official statistics for the registered labour force,
and therefore will not appear as registered unemployed. Yet from an
economic viewpoint, such people are in the labour force and are
unemployed.
2.0
OBJECTIVES
explain the meaning of unemployment

discuss the nature of unemployment
identify and explain the various types of unemployment
differentiate between private and social cost of unemployment.
3.0
MAIN CONTENT
3.1
Nature of Unemployment
Unemployment is a stock concept measured at a point in time. Its level

rises when the newly unemployed exceed people getting new jobs or
quitting the labour force altogether.
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You have to appreciate the fact that people working can be unemployed.
There are three ways through which people working can become
unemployed. Firstly, some people are sacked or made redundant (joblosers). Secondly, some are temporarily laid off but expect eventually to
be re-employed by the same company at a later date. Thirdly, some
people voluntarily quit their existing jobs. Nevertheless, the inflow to
the level of unemployment can also come from people not previously in
the labour force. For instance, unemployment level can rise from the
school leavers which constitute the new entrants. Furthermore, it can
also arise from people who once had a job, then ceased even to register
as unemployed, and now coming back into the labour force in search of
a job. These are the re-entrants.
Some people are bound to leave the unemployment pool in the opposite
directions. For instance, some get jobs while others give up looking for
jobs and leave the labour force completely. However, some of this latter
group may simply have reached the retirement age at which they can
draw a pension; many of them are discouraged workers. And discourage
workers are pessimistic about finding a job and therefore, leave the
labour force.
Explain the nature of unemployment.
3.2
Meaning of Unemployment
Unemployment is regarded as a situation whereby labour as a factor of

production is not utilized in productive activities. Hence, unemployment
of labour occurs when a person is willing and able to work and cannot
get a suitable job.
Unemployment can be classified into voluntary and involuntary. The
voluntary unemployment involves a situation when there is a job
opportunity but the unemployed person is not willing to accept the job
for reasons such as unacceptable wage rate, lack of interest on the nature
of the job, lack of mobility to where it is available, unfavourable
condition of service, etc.
The involuntary unemployment occurs when a person is willing to
accept a job at the prevailing wage rate but cannot get a job.
Differentiate between voluntary and involuntary unemployment.
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3.3
MACRO-ECONOMICS
Types of Unemployment
There are various types of unemployment which are classified in the

areas of frictional, structural, demand-deficient, or classical. Such types
of unemployment are discussed below.
(1)
Frictional Unemployment
This type of unemployment is the irreducible minimum level of

unemployment in a dynamic society.
It includes people whose physical or mental handicaps make them
almost unemployable, but it also includes the people spending short
spells in unemployment as they hop between jobs in an economy where
both the labour force and the jobs on offer are continually changing.
(2)
Structural Unemployment
It refers to unemployment arising because there is a mismatch of skill

and job opportunities when the pattern of demand and production
changes.
For example, a skilled welder may have worked for 25 years in
shipbuilding but is made redundant at 50 when the industry contracts in
the face of foreign competition. That worker may have to retrain which
is more in demand in todays economy. But firms may be reluctant to
take on and train older workers. Such workers become the victims of
structural unemployment.
(3)
Demand-Deficient Unemployment
This occurs when output exceeds aggregate demand for products.

Hence, a decline in demand for the products of the firms will bring
about a reduction in the usage of factors of production, which include
labour.
It is instructive to note that until wages and prices have adjusted to their
new long-run equilibrium level, a fall in aggregate demand will lead to
lower output and employment. Some workers will go to work at the
going real wage rate but will be unable to find jobs. Only in the longer
run will wages and prices fall enough to boost the real money supply
and lower interest rates to the extent required to restore aggregate
demand-deficient, and unemployment be eliminated.
Since the classical model assumes that flexible wages and prices
maintain the economy at full employment, classical economists had
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some difficulty explaining the high unemployment levels of the 1930s.

Their diagnosis of the problem was partly that union power was
maintaining the wage rate above its equilibrium level and preventing the
required adjustment from occurring.
(4)
Classical Unemployment
This describes the unemployment created when the wage is deliberately

maintained above the level at which the labour supply and demand
schedules intersect.
It can be caused either by the exercise of trade union power or by
minimum wage legislation which enforces a wage in excess of the
equilibrium wage rate.
The modern analysis of unemployment takes the same types of
unemployment but classifies them rather differently in order to highlight
their behavioural implications and consequences for government policy.
Modern analysis stresses the difference between voluntary and
involuntary unemployment under this consideration.
(5)
Search Unemployment
This occurs when a person refuses to accept an available job and

therefore remain unemployed in order to search for a better job. It is
voluntary because the person can find job which he is not ready to
accept. It is also involuntary because the person has not yet avail himself
or herself of the type of job he/she is interested in accepting.
(6)
Seasonal Unemployment
This is the type of unemployment that occurs on seasonal basis. For

instance, labour employed in farming activities during the rainy season
will become jobless during the dry season. Another good example is the
labour engaged in fishing activities, which is laid off during the period
of bad weather condition.
Identify and explain the various types of unemployment.
3.4
The Private and Social Cost of Unemployment
In this section we discuss the private and social cost of unemployment.

We begin with the private cost.
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3.4.1 The Private Cost of Unemployment

It is important to recall voluntary and involuntary unemployment for the
analysis. When individuals are voluntarily unemployed, they reveal that
they do better by being unemployed than by accepting the job offers
that they face at the going wage rate. Under these circumstances the
private cost of unemployment (the wage forgone by not working) is less
than the private benefits for being unemployed. What are these benefits?
First, the individual is entitled to transfer payments from the government
in form of social security allowance. These are of two kinds. Workers
who have previously contributed to the national insurance scheme are
entitled to unemployment benefit for first 12 months after they become
unemployed. Thereafter they become entitled to supplementary benefit,
the ultimate backstop in a welfare state such as Great Britain.
There are other benefits to be derived from being unemployed. First,
there is the value of leisure. By refusing a job, some people are
revealing that the extra leisure is worth more to them than the extra
disposable income derivable from a job. Second, some people expect to
get a better job after a temporary spell of unemployment. These future
benefits must be set against the current cost of lower disposable income.
When people are involuntarily unemployed, the picture changes.
Involuntary unemployment means that people would like to work at the
going wage but cannot find a job because there is excess labour supply
at the existing level of employment.
The distinction between voluntary and involuntary unemployment is
important because it may affect our value judgment about how much
attention should be paid to the unemployment problem. When
unemployment is involuntary, people are suffering more and the case for
helping them is stronger.
3.4.2 The Social Cost of Unemployment

For the analysis, it is necessary to distinguish between voluntary and
involuntary unemployment. When unemployment is voluntary,
individuals prefer to be good for the society as a whole.
There is one obvious discrepancy between individual benefits. For an
individual, unemployment and supplementary benefit are part of the
benefits of being unemployed. But these transfer payments give no
corresponding benefit to society as a whole. They may ease the
collective conscience about poverty and income inequality, but they are
not payments for the supply of any goods or services that other members
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of society may consume. To this extent, the value judgment that we

ought to support the unemployed becomes contentious.
However, this does not mean that society should go to the opposite
extreme and try to eliminate voluntary unemployment completely. First,
society is perfectly entitled to adopt the value judgment that it will
maintain a reasonable living standard for the unemployed, whatever the
cost in resource misallocation. Second, even in terms of allocative
efficiency, the efficient level of voluntary unemployment is certainly
above zero.
In a changing economy, it is important to match up the right people to
right jobs. Getting this match right allows society as a whole to produce
more output. Freezing the existing pattern of employment in changing
economy will eventually lead to a mismatch of people and jobs. The
flow through the pool of unemployment is one of the mechanism
through which society reallocates people to more suitable jobs and
increases total output in the long run. If unemployment benefits make
this transition smoother, society may gain.
Two points emanating from earlier analysis are also relevant here. First,
even when unemployment is high, flows both in and out of the pool are
large relative to the pool itself. Second, people who do not get out of the
pool quickly are in danger of stagnating when unemployment is high.
Involuntary unemployment has an even higher social cost. Since the
economy is producing below capacity, it is literally throwing away
output that could have been made by putting these people to work.
Moreover, involuntary unemployment may entail more human and
psychological suffering than voluntary unemployment. Although this is
hard to quantify, it is also part of the social cost of unemployment.
Differentiate between social and private cost of unemployment.
4.0
CONCLUSION
From the foregoing analysis, you can understand the meaning and types
of unemployment. You can also appreciate the nature of unemployment
as well as the social and private cost of unemployment, which do
influence the nature of policies that may be initiated by the government
to cushion the effects of unemployment, and by extension the measures
adopted to stem the economic problem.
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5.0
MACRO-ECONOMICS
SUMMARY
This study unit has been used to discuss the meaning and nature of
unemployment. It also discusses the various types of unemployment.
Lastly, the unit also discusses the social and private cost of
unemployment.
6.0
Mention and explain the various types of unemployment.
7.0

House Pvt Limited.
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UNIT 3
DEMAND AND SUPPLY OF MONEY
CONTENTS
1.0
2.0
3.0
4.0
5.0
6.0
7.0
Introduction
Objectives
Main Content
3.1
Money and Functions of Money
3.2
The Demand for Money
3.2.1 Concept of Demand for Money
3.2.2 Motives for Holding Money
3.2.3 Factors Affecting Demand for Money
3.3
Supply of Money
3.3.1 Concept of Supply of Money
3.3.2 Factors Affecting Money Supply
Conclusion
Summary
1.0
INTRODUCTION
Money as a legal tender in any economy has been introduced to ease the
process of economic transactions. In advanced economies, money as a
means of payment (such as coins and bank notes) has assumed diverse
forms and nature that it now includes representative money such as
cheques, stamps, electronic cards, bank drafts, bankers cheques, among
others. In the less developed countries, the most popular forms of money
are the coins and bank notes. These are known as legal tender because
they must be accepted by everybody in economic transactions in such
countries.
This study unit is used to discuss the motives which make people to hold
some quantity of money (demand for money) beyond its subsistence use
and the factors that influence the demand for money. In addition, the
unit is also used to discuss the quantity of money in circulation (supply
of money) at any point in time and the factors, besides government
influence, that affect its supply in any given economy.
2.0
OBJECTIVES
explain the meaning and functions of money

discuss demand for money
discuss the three motives for holding money
explain factors affecting demand for money
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discuss supply of money

explain factors affecting supply of money.
3.1
Meaning and Functions of Money
MACRO-ECONOMICS
Money can be defined as any asset that is generally accepted as the

means of payment for goods and services and in settlement of debts
within any economy. According to Begg, Fischer and Dornbusch
(2000), money is any generally accepted means of payment for delivery
of goods or settlement of debt. Hence money is a medium of exchange
for goods and services, and by extension, it is acceptable for the
settlement of debts and any other financial obligations.
The above views on the essence of money portray that money is
usually not wanted for its own sake, but for what it garner for the person
who possesses it. Forms of money include mainly coins and paper notes.
However, there are other forms of money which are distinct and
different the form group. These are regarded as near-money or
representative money since they have to be converted into physical cash
before they can easily be used in exchange of goods and services as well
as in settlement of debts.
The functions of money include the following:
1.
Medium of Exchange
This is the foremost function of money since without being generally

accepted for exchange it seizes to be money and a legal tender. It means
that money performs the important function of ensuring that the process
of exchange in the economy is facilitated. Hence, the legal tender as the
official currency in any economy replaces the cumbersome process of
barter.
2.
Store of Value
The wealth possessed by an individual can be saved in form of money

for the future use. This implies that money serves as a means by which
we can create a stock of wealth which can be converted into use in the
future.
3.
Standard of Deferred Payment
Money enables people to engage in credit transactions, which can be

assessed in monetary terms for the future settlement. Hence, the
presence of money makes possible the practice of borrowing and
lending as well as credit purchases. It also facilitates the postponement
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to future date spending on some commitments in business, households

and government circle.
4.
Unit of Account
Money makes it possible to denominate the goods and services that are
transacted on in the economy. In other words, money as a unit of
account, serves as a common denominator used for measurement of
goods and services. Therefore, money as a unit of measurement enables
the prices of goods and services to be determined.
5.
Measure of Value
Money serves as a common standard by which the value of commodities

can be determined. In other words, money as a unit of account different
values of goods and services to determined. Hence, money facilitates the
measurement of differences in the values of goods and services.
1.
2.
Explain the term money.

Identify and explain the functions of money.
3.2
The Demand for Money
3.2.1 Concept of Demand for Money

The demand for money refers to the amount of money which people are
willing to hold in a given period of time. In discussing the demand for
money, our main focus will be to look at the variables that actually
motivate people to hold part of their wealth in money assets as opposed
to other assets. It is important to note that because holding money has a
cost, there is a limit to which people can hold money.
Various theories on the demand for money explain why people are
willing to hold cash balances as opposed to other assets which can be
easily converted into cash. There appears to be a consensus of opinion
among all monetary theorists that among other factors, income and rate
of interest are important parameters that will affect the demand for
money in any given economy.
Explain the term demand for money.
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3.2.2 Motives for Holding Money

The three motives for holding money, as propounded by Lord Maynard
Keynes in his liquidity preference theory, are as highlighted and
discussed below.
1.
Transactions Motive
The need for people to hold some money for daily transactions is
referred to as the transactions motive. In other words, transactions
motive of holding money refers to the need to hold money to meet up
various transactions that are carried out on a daily basis. Keynes argued
that there is hardly any economic agent whose cash receipt perfectly
matches its cash payment at all times.
For instances, most workers receive their income on a monthly basis,
some weekly, etc. However, not all necessities could be bought and
stored up till the next salary period. Even if this is feasible, other
expenses on items such as transport to work, newspaper, feeding at
work, etc, are met on daily basis or at shorter interval than receipt of
income. Most businesses find their operational demands in this similar
situation. For instance, goods may have to be sold on credit or on
monthly basis but daily operational expenses have to be met.
The difficulty in synchronizing the inflow and outflow of funds creates
the need to hold some cash to meet daily expenses till the next cash
inflow period. Money held for the purpose of ameliorating this situation
is known as transactions motive. The amount of money that an
individual will hold for the transactions purpose is a function of the level
of income. The higher the level of income earned by an individual the
higher the amount of money that will be held for transactions.
Transactions motive is also influenced by such other factors like
intervals of time between workers earnings, family size, life style,
consumption habit, etc.
2.
Precautionary Motive
Precautionary motive refers to holding money for unforeseen

circumstances and eventualities that may arise without notice.
According to this postulate, emergency situations such as sudden illness,
damages to household facilities, arrival of unexpected visitors
necessitate the need for holding money for precautionary motive.
Money people hold with which to meet such unexpected commitments
in life is said to be held for precautionary purpose. For instance, for a
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businessman, there may be the need to set some money aside for the
mere fact that cash requirements for operations may exceed what has
been budgeted for in the cash flow forecast or some debtors from whom
payments are due may fail to pay.
In the government circle, for instance, the tax revenue generated may
fall short of expected amount and this calls for precautionary measure in
the budget. Furthermore, national exigencies such as earthquake,
drought, flood, outbreak of communicable diseases, or fire outbreak may
necessitate unexpected public spending. These emergencies do give rise
to the need for holding money for the purpose of precautionary
expenditure.
3.
Speculative Motive
Under this consideration, Lord Keynes posited that people hold money
above their active balance requirements so that they may make profits
by speculating on the prices of bonds. According to Keynes, when
prices falls suddenly, people will want to use the opportunity to
purchase bonds, assets, goods, etc; and resell later when prices
appreciate. He linked the speculative demand with interest rate which
reflects movement of the prices of bond.
Keynesians believe that there are circumstances when an economic unit
will prefer to hold money in excess of their transactionary and
precautionary requirements. People do hold money in expectation of fall
in prices of goods, so that they can buy and later sell them when prices
rise. Money that people hold to take advantage of price changes is
known as speculative motive.
Identify and explain the three motives for holding money.
3.2.3 Factors Affecting Demand for Money

The demand for money is a function of factors which are listed and
explained below.
1.
Level of Income
A person whose earning is of relatively large sum would be expected, all

things being equal, to have more cash balances for transactions,
precautionary and speculative motives than an individual whose income
is barely enough to take care of daily survival or for subsistence
purpose. Hence, the latter is only preoccupied with the transactions
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motive for holding part of income compared to the former who can
provide for all the three demand motives.
2.
The Size of Individual Wealth
An individual who has a large wealth would be expected, all things

being equal, to have more of each of the various investment assets that
are accommodated in his wealth portfolio. These assets would include
money. A person who has a total wealth of say N15million, for example,
would have more money in his wealth portfolio than a person whose
total wealth holding is just N750,000. When the wealth holding
increases, demand for money will be expected to increase just as
demand for other assets will be expected also to increase within the
portfolio framework.
3.
Interest rate
Interest refers to the cost of money, the alternative forgone or the

opportunity cost of holding perfectly liquid balances as opposed to
interest bearing securities. When interest rate rises, the opportunity cost
of holding money will rise. It implies that it will become more
expensive to hold money. Hence, the demand for money will
consequently fall. On the other hand, low rate of interest will increase
the incentive to hold cash as opposed to interest bearing securities
because what is lost is insignificant particularly when one considers the
transaction costs involved in the acquisition and realization of interest
bearing securities.
4.
Individual Preferences
According to the monetarists, people prefer to hold money because of

the confidence it brings to the holder. The importance that people attach
to money as a form of wealth, given the same level of opportunity cost
sill vary and this will affect individuals demand for money. Some people
attach enormous value to the convenience of liquidity and confidence
which money possesses, as opposed to other assets like bond, physical
goods and other financial assets.
Such individuals believe that the liquidity and confidence that money
generates constitutes some form of implicit yield and it is the
comparison of this implicit yield with the explicit yield which is the
interest forgone, that actually influences a persons propensity to hold
cash. The greater the value that an individual attaches to these implicit
yields, the higher will be his demand for money and vice-versa.
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Identify and explain the factors that influence demand for money.
3.3
Supply of Money
3.3.1 Concept of Supply of Money

The supply of money refers to the amount of money which is available
in an economy at any given time; which is in sufficiently liquid and
available for immediate spending. Hence, it implies that supply of
money at any moment is the total sum of all the money holdings of all
the members of the society. Money supply in any economy is expressed
as M1, M2 or M3.
M1 refers to the total amount of currency held by the public or currency
in circulation, plus demand deposits.
in circulation plus demand deposits plus time deposits.
in circulation, plus demand deposits plus time deposits plus banks
loans.
The loans granted by the banks are considered herein in M3 since such
loans increase the stock of money in circulation in the economy. When
the banks lend out money, the borrowers receive extra money as injected
into the money in circulation. Needless to say that nobody else has any
less money as a result of the loans.
The existing depositors could still write cheques against their deposits.
The banks take the amount of loans out of the vaults and put it back into
circulation, and therefore, they succeed in increasing the money supply
in the economy.
Identify and discuss the various components of money supply.
3.3.2 Factors Affecting Money Supply

The fact remains that the monetary authorities such as the central bank is
the major determinant of the money stock or supply of money. This is in
consideration of the fact that regulation of the monetary base and control
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over most of the other variables that affect money supply are vested in
them.
There are other variables or factors that affect money supply in any
economy as highlighted and discussed below.
1.
Monetary Base
The money supply has the potential to increase if the central bank
expands the monetary base. The monetary base or high powered money
is the total of bank reserves plus currency in the hands of public. These
two important components (bank reserves and currency in circulation)
constitute the uses of the monetary base and are naturally influenced by
the central banks policies as well as the behaviour of both the public
and the banks.
For instance, if the central bank increases the monetary base by allowing
commercial banks more liquidity in excess of reserve requirements, all
things being equal, there will be more money available for supply in the
economy.
2.
Credit Creation
The extent to which commercial banks are allowed to create credits in

the process of financial intermediation by giving out loans will affect the
extent of money supply. This is hinge don the fact that the demand
deposits they create through lending facilities are part of the money
supply. When banks create credit, the lending facility or loans and
overdrafts will in turn lead to demand deposit.
The money multiplier is the magnitude by which the money supply will
increase if there is any increase in deposit. The higher the level of
deposits in banks, the higher their ability to create credit, and the more
credit they lend out to the investing public, the more the level of money
supply in the economy.
3.
Portfolio Behaviour of the Public
This is related to the banking habits of the public. For instance, if most
people keep their money in bank, the banking system will have liquid
reserves to lend out and create derivative deposit which is the deposit
created through lending. Deposit created through customers deposit is
the primary deposit.
The currency outside the banking system constitutes leakages in the
money creation process and the less these leakages are the more the
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ability of banks to create derivative deposit and by extension, increase

money stock in circulation. In developed financial system where
banking habit is well adopted and imbibed, the marginal propensity to
hold currency will be very low. The smaller this marginal propensity to
hold currency the higher will be the bank deposit and therefore, the
higher the money supply. If the marginal propensity to hold currency
increases, the liquidity of commercial bank will nose dive and by
implication, money supply will similarly fall.
4.
Policies of Monetary Authorities
The policies of the monetary authorities such as the central bank

employed in reaction to the mood of the economy will have effects on
money supply. The sale of marketable securities such as treasury bills,
and treasury certificates, for example, will facilitate a reduction in
money supply causing a reduction in overall liquidity of the economy.
Monetary policies such as the use of special deposit and the issuance of
stabilization security also affect money supply in the economy.
Monetary policies such as legal reserve ratio and rediscount rate
adjustment will also have the same effect on money supply. Central
bank being a supervisory authority on supply of fund to the banking
system, its manipulation of the re-discount rate will affect commercial
banks lending rate. Demand for loan is determined principally by the
rate of interest, and by implication, bank lending will fall when interest
rate rises. The fall in demand for bank credit as a result of a rise in
interest rate will cause a contraction in money supply.
5.
Foreign Exchange Transactions
The availability of foreign exchange will have the tendency to increase

domestic money supply. The supply of foreign exchange in the economy
comes in form of personal incomes or transfers of foreign currency and
foreign exchange generate through by business entities which can be
sold to an authorized dealer or deposited it in foreign exchange
domiciliary account. This does not affect domestic money supply
because only deposits in local currency will be part of the officially
designated money supply.
On the other hand, if such magnitude of foreign currency is converted
into local currency, the equivalent amount in local currency will increase
the currency in circulation; therefore causing an increase in money
supply in the economy. On the other hand, when an individual wants to
import, he will need to buy foreign exchange, transferring local currency
to the central bank and that will reduce money supply.
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In essence, therefore, dealings in foreign exchange will have the effect

of locking up part of money supply through demand for foreign
exchange for import or expanding money supply through sale of foreign
exchange generated from exports of goods and services.
Identify and discuss factors that influence money supply.
4.0
CONCLUSION
From the foregoing analysis, you can understand the meaning, forms
and function of money. You can also appreciate the motives which
inform the tendency for people to hold money as well as the factors
which influence the demand for money. You have learnt the nature of
the supply of money and the factors that influence the quantity of money
in the economy at a given point in time.
5.0
SUMMARY
This study unit has been used to discuss the meaning, forms and
functions of money. It is also used to discuss the demand for money,
determinants for the demand for money. Lastly, the unit is also used to
discuss supply of money and the factors that influence the quantity of
money in circulation within the economy at a given point in time. The
next study unit is used to discuss financial institutions.
6.0
1.
2.
Differentiate between demand for money and supply of money.

Mention and discuss factors that influence the supply of money.
7.0

House Pvt Limited.
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UNIT 4
MACRO-ECONOMICS
FINANCIAL INSTITUTIONS
CONTENTS
1.0
2.0
3.0
4.0
5.0
6.0
7.0
Introduction
Objectives
Main Content
3.1
The Central Bank
3.1.1 Central Banking in the Economy
3.2
Commercial Banks
3.2.1 Meaning of a Commercial Bank
3.2.2 Functions of Commercial Banks
3.3
Development Banks
3.4
Insurance Companies
3.5
The Stock Exchange
3.6
Mortgage Banks
3.7
Foreign Exchange Market
Conclusion
Summary
1.0
INTRODUCTION
Financial institutions are the financial intermediaries between the savers

of surplus funds and the investors who are in need of extra funds to fund
business undertakings. The main financial institutions in Nigeria are the
commercial banks that bestride the countrys economic landscape like
colossus. The other financial institutions have become captives to the
commercial banks because they are mostly such institutions parent
companies.
The central bank is at the apex position in the financial system of any
economy. The bank controls the other banks in the country. The other
financial institutions include development banks, insurance companies,
the stock exchange, mortgage banks, and foreign exchange market. In
this unit, you are exposed to the discussion on financial institutions in
the economy.
2.0
OBJECTIVES
explain the meaning of central bank

identify and discuss the functions of the central bank
discuss nature and functions of commercial banking
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mention and discuss the functions of commercial banks

discuss the importance of mortgage banks
identify and explain functions of insurance companies
discuss the significance of the stock exchange in the economy
explain the importance of mortgage banks.
3.0
MAIN CONTENT
3.1
The Central Bank
3.1.1 Central Banking in the Economy

The central bank of any economy constitutes the apex of the financial
system. In other words, the central bank occupies the apex position to
other financial institutions in the economy. Hence, it regulates controls
and supervises the operations of all other financial institutions in that
economy. Its operations are very strategic in national economic
management and planning of the economy.
3.1.2 Functions of Central Bank

The central bank as the most strategic financial institution in the
economy performs the following functions.
1.
Banking functions
These functions include the following:

i)
ii)
iii)
iv)
Keeps the government bank accounts

Lends money to the government;
Acts as a bankers bank, i.e. banker to other financial institutions;
Serves as clearing house for commercial banks.
2.
Agency Functions

i)
ii)
iii)
iv)
v)
118
Provides exchange medium i.e. notes and coins on behalf of the

government;
Acts as registrar of government companies and corporations;
Manage the underwriting, issue, sale and liquidation of
government debt instruments like treasury bills, loan stocks, etc.;
Administers the countrys foreign exchange regulations and
maintains the international value of the currency;
Keeps the governments gold reserve and maintains the
Exchange Equalization Account;
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vii)
Represents the country on international financial institutions like

the World Bank, African development Bank, International
Monetary fund, etc. and maintains link with and account of, these
bodies; and
Manages the national debt.
3.
Advisory functions

i)
ii)
iii)
is the chief monetary adviser to the federal government;

Undertakes research on the various facets of the economy and
provides report to the government for necessary policy actions;
and
co-ordinates returns from financial institutions.
4.
Regulatory Functions

i)
ii)
iii)
iv)
acts as the watchdog of the economy, regulates money supply,

interest rate and formulates necessary monetary policies in line
with the dictate of the economy as may be from time to time;
maintains the integrity of the of banking system through
supervision of banks, banking examination and invoking
necessary sanctions to ensure conformity and high ethical
standard;
supervises the creditability of institutions entering the banking
system;
initiates and advises the government on regulations or
amendment to regulations as may be necessary to further
strengthen the financial system.

Identify and discuss functions that central bank performs in the
economy.
3.2
Commercial Banks
3.2.1 Meaning of a Commercial Bank

A commercial bank engages in the business of receiving from the public
the money which is payable on demand and making advances to
customers. In other words, a commercial bank is an institution that
engages in financial intermediation. A commercial bank, therefore, has
the business operations of receiving money from outside sources as
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deposits and creating credits through loan facility. Hence, banking

business can be described as that of trading in money and other financial
assets with a view of making profits.
A commercial bank can also be defined as a financial institution which
accepts money and other valuable for safe custody. In other words, a
commercial bank can be referred to as an institution dealing in money,
an intermediate party between the borrower and the lender and therefore,
a company that specializes in financial intermediation. This is because
the bank mobilizes funds from those who have surplus to part with
temporarily and channels such funds to the prospective borrowers in the
economy.
Commercial banks in Nigeria operate branch banking. Branch banking
is characterized by a single banking company conducting operations on
the basis of branch network, maintaining many branches in many major
towns and cities within the country.
Differentiate between a central bank and a commercial bank.
3.2.2 Functions of Commercial Banks

The commercial banks provide numerous services to the banking public
in the country. Such functions of commercial banks are as follows.
1.
Mobilization of Savings
A major function of commercial banks is the mobilization of savings

through the provision of facilities as saving institutions. As funds are
mobilized through the various types of accounts operated by the
customers, the commercial bank in turn makes the funds available to
investors for investment purposes by the process of granting credit
facilities to them. Hence, these funds are made available to business
entities to enable them expand their productive capacity and to
individuals and households to facilitate consumption.
2.
Granting Credit Facilities
The hallmark of commercial bank operations is the extension of credit to

worthy borrowers. In making credit to the banking public, commercial
banks render great economic services. Their actions impact positively on
the economy because production is increased, capital investments are
expanded and a higher standard of living for the citizens is realized. The
credits of the commercial banks are given out in the forms of loans and
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overdrafts which are repayable by the beneficiaries. The commercial

bank is required by the shareholders to earn reasonable returns on loan
facilities through interests charges associated with lending.
3.
Agents of Funds Transfer
Another major function of a commercial bank is by acting as agent of

payment and facilitating the transfer of funds for their customers. This is
usually carried out through operations such as the use of cheques as a
means of payment, carrying out of standing orders, mail or telegraphic
money transfer, open credit or cashing credit, cards and direct debiting,
among others. By using these facilities, the bank assists her numerous
customers to make funds available from one point to another, and also
honour payment obligations on behalf of their customers.
4.
Loan Syndication Services
Commercial banks do also, on behalf their customers, arrange loan

syndication services whenever approached to do so. Loan syndication
arises whenever a customer requires a huge loan facility which a single
bank may consider as being too risky for one bank to carry in its loan
portfolio. Hence, loan syndication involves a bank sourcing for other
willing banks who will be ready to bear the burden, by sharing to
provide a part of the required loan facility, thereby spreading the risk.
This service enables very huge financial resources to be mobilized for
customers when such funds are needed.
5.
Keeping of Valuables
Commercial banks also have one of their functions as assisting their

various customers to keep their valuables in safe custody. Such
valuables like wills, certificates, jewelleries, deeds of title to land, etc,
are usually accepted by the banks for safe custody, thus avoiding losses
through theft, misplacement or destruction through fire outbreak.
6.
Investment Advisory Services
Commercial banks can also offer investment and business advisory

services to their customers by advising them on areas of profitable
investment opportunities. These investment advices are necessary
because the success of a customers business will mean that the bank too
will benefit. In this regards, banks have trained personnel capable of
providing superlative advice on investments opportunities.
7.
Brokerage Services
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Commercial banks also engage in brokerage services for their

customers. They participate in floating new securities for their
customers and also assisting their customers to buy into new securities.
Therefore, bonds, stocks and shares are bought and sold besides
collection of dividends on behalf of their customers.
8.
International Trade Services
Commercial banks also assist their customers to facilitate international

business transaction through the provision of needed foreign exchange
and international payments through the issuance of letters of credit and
other relevant documents. They also issue travelers cheques to people
traveling abroad as well as the conversion of local currency into foreign
currencies. They also give vital information concerning their customers
as may be required by foreign business partners.
9.
Status Enquiry Services
Commercial banks in their daily operations also provide reference

reports on behalf of their various customers regarding status profile
about the standing of their customers when other business partners seek
to know the credit worthiness or position of their business associates.
These references when given by a commercial bank on behalf of its
customer, goes a long way to boost the image and business of such a
customer.
10.
Trusteeship and Executorships Services
Commercial banks also provide sundry services such as trusteeship and

executorships of wills, estates, investments and businesses on behalf of
their customers where such customers requests the bank to become their
surrogate managers over such property or investments.
11.
Execution of Monetary Policies
A major function of the commercial banks is in the execution of

monetary policies of government through compliance with the directives
and regulation of the central bank in its operations. The central bank on
behalf of the government in the quest to stabilize the economy, do
initiate policies from time to time which are aimed at regulating the
entire economy. The commercial banks constitute the implementing
agents by carrying out these directives as stipulated by the central bank
in their operations.
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Identify and discuss the functions of commercial banks.
3.3
Development Banks
The development banks are the banks established by the government to

encourage the economic growth and development of the country.
Presently, examples of such banks in Nigeria are the Bank for Industry
(BOI) and the Nigerian Agricultural, Cooperative, and Rural
Development Bank (NACRDB). The development banks by virtue of
their mandate are banks that specialize in providing long-term and
medium-term loans for the development of industries and participate in
development projects in any sector of the national economy.
These banks are sometimes involved in direct investments (equity
holdings) to accelerate development projects. They do also periodically
conduct detailed feasibility studies in some areas of the economy in
order to identify development projects that could be financed from
internal funds available or that could be financed through internal and
external participation.
The functions of development banks include the following:
i.
ii.
iii.
iv.
v)
vi)
vii)
viii)
ix)
x)
To stimulate economic development of the country.

Harnessing funds for industrial and agricultural development
Encourage savings form small income earners.
Introduce appropriate strategies for channeling micro credits to
small investors.
Delivery of micro credits to businessmen and women.
Make funds available to industrialists for the purpose of industrial
expansion.
Liaise with development partners for encouragement of industrial
development in the country.
Formulate appropriate policies that can encourage industrialists to
invest in strategic areas of the economy.
Develop extension services to help industrialists for efficient
operations.
To engage in other operations necessary to boost industrial
productions.

What are the functions of the development banks?
3.4
Insurance Companies
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Insurance companies are financial institutions established for the

purpose of accepting risks and losses as they occur in business
enterprises in any economy. In the course of operations they collect
premiums which form a pool out of which the insured parties are
compensated in the event of loss.
Insurance companies insure their clients against risks and uncertainties
of two kinds. The first group refers to risks and uncertainties which can
be calculated and forecast with some measure of accuracy. Examples of
such risks are those associated with burglary, fire outbreak, accidents,
etc.
The second group refers to those risks and uncertainties which cannot be
calculated or forecast. Examples of these risk and uncertainties are
flood, thunder, volcano, earthquake, typhoon, and business inefficiency,
among others.
Insurance business thrives on pooling of risks, which involves accepting
risks from a large number of people and collecting contributions through
premiums to generate a fund, out of which compensations are paid to
those who suffer one kind of loss or the order.
An insurance company can sometimes spread the clients risks by reinsuring part of the risks with other insurance companies. The issue of
re-insurance arises because the risk involved is greater than what a
particular insurance company can cope with considering its capital and
expertise.
The functions of insurance companies include the following:
i)
They assume responsibility for business risks of their clients by

accepting to compensate them in the event of incurring losses
insured against.
ii)
They help to mobilize funds which can be accessed by investors
for industrial development.
iii)
They pool financial resources of individuals and corporate
entities through premiums with which to participate in financial
intermediation.
iv)
They help the industries to manage their risks and therefore, help
their clients to transfer their business risks to another party.
v)
Insurance companies facilitate business operations by helping
corporate entities to shed their operational risks.
vi)
They facilitate educational development through education
endowment policy in their operational portfolio.
vii)
They facilitate economic growth and development in the
economy.
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What are the functions of insurance companies?
3.5
The Stock Exchange
The stock exchange is the nerve centre of the capital market. The capital
market itself is a network of facilities for mobilizing and dealing on
medium and long term funds. The monetary instruments traded in the
sock exchange are those whose maturity period is from 5 years and
above; e.g., bonds, shares, loan stock, etc.
In the case of Nigeria, the capital market has two segments-the primary
segment and the secondary segment. The primary segment is the
situation where firms issue new securities, debt or equity to investors
and are sold through investment bankers who act as agents for the
companies selling the securities or instruments. It is a major source of
capital for companies.
The secondary segment of the capital market on the other hand is the
market where the old securities are bought and sold. Since the stock
exchange is the melting pot of the capital market, existing securities
purchased initially at the primary market are then traded in the stock
exchange.
The members of stock exchange are stockbrokers and jobbers.
Stockbrokers buy and sell securities on behalf of the investing members
of the public for a commission called brokerage. The stock jobbers buy
and sell securities on their own account to earn profits called jobbers
turn. They do specialize in particular types of securities. The Nigerian
Stock Exchange has only stockbrokers as it dealing members due to its
level of development.
The functions of the stock exchange include the following;
1. It mobilizes financial resources for industrial investment.
2. To fill the resources gap for long term and medium term borrowing
and lending by Nigerians.
3. To provide avenues for the Nigerian government and its agencies to
mobilize long and medium term capital for the economic
development of the country.
4. To allow for free interaction of foreign businessmen and their
Nigerian counterparts to trade in foreign business shares.
5. To provide the framework for a code of conduct to regulate the
activities of transactions in securities.
6. To oversee the operations of the market to ensure fair trading in
dealings by the Exchange members.
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7. To ensure fair pricing of new issues of investment securities.

8. To develop the capital market in the country by ensuring adequate
branch network in the economy.
9. Ensure the listing of public limited companies on the Exchange.
10. To foster public confidence in the operations of the Exchange by
guiding against abuses by dealers.
11. It provides a ready market for buying and selling of long-term
securities such as bonds, shares, stocks, etc.
12. It provides new enterprises with a guide to terms on issuance of new
issues.
13. It serves the capital market by giving liquidity to long-term capital or
securities which can be used permanently by corporate bodies.
14. It encourages the investing public to invest in long-term securities
since the Exchange serves as an avenue to dispose off such securities
whenever the need arises.
15. It guides and protects the investing public by influencing the
members of Exchange to keep to the markets regulations and
requirements.
What are the functions of the stock exchange?
3.6
Mortgage Banks
These are financial institutions established to engage in the business of

facilitating housing development. Their operational activities, therefore,
are geared towards financing personal buildings of their customers or
houses built for outright sale to the public.
The customers of mortgage banks save with the intention of
accumulating enough amount of money to meet the required portion of
the estimated cost of buildings. This enables the customers to secure the
remaining portion of the total cost the building as loan from the bank
with to finance the property for eventual ownership. The property
financed by the bank serves as the collateral security.
In advanced countries, theses banks are financed by the private
investors. This is not the case in developing countries where mortgage
bans are financed by both the government and private investors. For
instance, in Nigeria, some mortgages institutions are financed by the
government while others are financed and established by private
investors.
The main function of mortgage institutions is that they mobilize savings
of their customers and invariably grant them loan facilities with which
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to finance housing estate either by outright purchase or by building their

own houses, which meet their tastes and preferences.
In order to encourage private housing ownership, as a matter of policy
by the government, the interest rate for mortgage loans is generally low
and the repayment periods are usually relatively over a long period of
time.
Discuss the importance of mortgage banks in an economy.
3.7
Foreign Exchange Market
This is the market which provides the forum for the sale purchase of
foreign exchange or foreign currency. In this market, the countrys
currency like the naira is exchanged for other currencies from other
countries. Examples are US dollars, British pound sterling, Japanese
Yen, and Italian lira, among others.
In Nigeria, the nerve centre of foreign exchange market business is
Lagos which is the commercial melting pot of the country. Therefore,
Lagos acts as the clearing house, balancing the demand for, and supply
of foreign currencies required by individuals and corporate bodies
within the country.
The participants of the Lagos foreign exchange market are Central Bank
of Nigeria and commercial banks. The apex bank being the regulatory
authority in the financial system of the country, exercises strict control
over the transactions in the foreign exchange market. The central bank
has the responsibility of ensuring that no foreign currencies are taken
out of the country outside its control so as to conserve the nations
foreign exchange earnings.
Price determination in the foreign exchange market is effected through
the interaction between the forces of demand and supply. The structure
of foreign exchange market is highly competitive because there is no
single buyer or seller is large enough to influence the market price.
However, the central bank in Nigeria does intervene in the foreign
exchange market to ensure sanity so as to maintain price stability in the
economy generally.
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Discussion the importance of foreign exchange market in the economy.
4.0
CONCLUSION
From the foregoing analysis, you can understand the nature and types of
financial institutions. You can also understand the fact that the central
bank occupies the regulatory position over the operations of the
financial system in any economy. The commercial banks occupy a
strategic position in the scheme of operational activities of the financial
institutions in the economy since all others depend on the vital services
being performed by them. You can also understand from above analysis
that all other financial institutions aside central bank and commercial
banks still carry out important functions in the economy.
5.0
SUMMARY
This study unit has been used to discuss the nature and types of financial
institutions which operate in the economy. It is also used to discuss the
nature and functions of the central bank as well as the commercial
banks. In addition, the unit is also used to discuss mortgage banks, stock
exchange, and insurance companies. Lastly, the unit also considers the
role of foreign exchange market in the finiancial system of the economy.
The next study unit is used to discuss financial institutions.
6.0
1.
2.
Differentiate between commercial bank and development bank.

Mention and discuss the functions of the central bank.
7.0

House Pvt Limited.
UNIT 5
128
BALANCE OF TRADE AND BALANCE OF

PAYMENTS
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MACRO-ECONOMICS
CONTENTS
1.0
2.0
3.0
4.0
5.0
6.0
7.0
Introduction
Objectives
Main Content
3.1
Balance of Trade
3.2
Meaning and Components of Balance of Payments
3.3
Importance of Balance of Payments
3.4
Shortcomings Inherent in Balance of Payments
3.5
Causes of Disequilibrium in Balance of Payments
3.6
Removal of Disequilibrium in Balance of Payments
Conclusion
Summary
1.0
INTRODUCTION
Originally, balance of payments was used to denote an excess of

payments over receipts in international trade between two countries.
Under gold standard this excess meant an outflow of gold from the
country. The term, however, soon began to be used in the natural sense
of the state of balance of international accounts, whether negative or
positive. Consequently, we speak of the term balance of payments
whether there is an outflow or inflow of gold.
Basically, the term balance of payments as used in international trade
covers the entire relationship between imports and exports of goods and
services. Therefore, the subject is no more restricted to the situation of
excess of payments over receipts. The mercantilists of those days
prefixed the adjectives favourable and unfavorable to denote
respectively gold inflows and outflows. Both adjectives were, however,
rejected during the process of classical reaction to mercantilism on the
plea that it were the commodities and not gold that constituted real
national wealth and that there was nothing favourable about a surplus
export of commodities in exchange for gold.
This consideration led to the use of such prefixes as active and
passive and positive and negative. These terms were also found
equally unsatisfactory. For example, there is nothing passive about a
gold outflow or active about a gold inflow. The terms in current use
are surplus and deficit as these do not suffer from any important
ambiguity and are also in harmony with the current accounting practice
in trade.
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2.0
MACRO-ECONOMICS
OBJECTIVES
explain the meaning of balance of trade

discuss the nature of balance of payments
identify components of balance of payments
differentiate between balance of trade and balance of payments
discus the importance of balance of payments
identify the causes of disequilibrium and ways of ameliorating it.
3.0
MAIN CONTENT
3.1
Balance of Trade
A country exports and imports many visible goods and invisible services
in international trade. Invisible services include tourism, shipping and
other transport services, banking and insurance services for whose
exports and imports payments are made and received by the country in
international trade.
A country's balance of trade refers to the difference between the value of
imports and exports of commodities or visible items of trade. The
balance of payments is also more comprehensive in the sense that it
includes the total debts and credits relating to all the items on account of
which a country makes payments to and receives payments from rest of
the world. In short, the balance of trade is only a part of the balance of
payments. The balance of trade is simply the difference between the
value of commodity in terms of exports and imports.
The balance of trade is usually the largest component of international
balance of payments of a country. The other major components of a
country's balance of payments are the payments made to and received
from rest of the world on account of interest, dividends, investments and
loans, government expenditure, gold and capital movements, gifts, and
reparations payments, among others.
A favorable balance of trade may co-exist with an adverse balance of
payments and vice versa. For example, a countrys balance of trade may
be unfavourable but her balance of payments can be favourable. This
may arise from the fact that in exports of invisible items of trade (such
as services) and interest earnings on her foreign investments she
received more in payments from rest of the world than she paid to rest of
the world on account of imports of goods in international trade
transactions.
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Explain the term balance of trade.
3.2
Meaning and Components of Balance of Payments
The balance of payments of any country refers to the difference between

the total value of exports and the total value of imports of goods and
services. The exports or imports comprise both the visible and invisible
items of trade in terms of goods and services.
The international balance of payments of a country is a statistical record
kept in the form of a balance sheet comprising all her foreign economic
transactions during any given period of time. In other words, it presents
a summary account of all international transactions of a country during a
certain given period of time.
According to the International Monetary Fund, "the balance of payments
for a given period is defined ... as a systematic record of all economic
transactions during the period between residents of the reporting
countries According to the US Department of Commerce, "the
balance of payments of a country consists of the payments made within
a stated period of time between the residents of that country and the
residents of foreign countries.
The balance of payments may be defined in a statistical sense as an
itemized account of all transactions involving receipts from foreigners
on the one hand, and payments made to foreigners on the other. Since
the former relates to the international income of a country, they are
called 'credits,' and since the later relates to international outflows, they
are called 'debits'.
According to Kindleberger, "the balance of payments of a country is a
systematic record of all economic transactions between the residents of
the reporting country and residents of foreign countries during a given
period of time." It comprehends all payments made by a country to other
countries and all receipts which accrue to a country from abroad.
Since balance of payments is a systematic record of a country's total
money receipts from and payments to abroad, the difference between
receipts and payments is either surplus or deficit. A country's total
money receipts refer to the total revenue that accrues to its residents
while the total payments refer to the payments made by the residents of
that country.
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Expressing a countrys residents' total receipts, R, and their total payments, P, into their domestic and foreign components and if the
domestic receipts and domestic payments are identical, then international balance of payments, B, of a country can be expressed as
follows.
B = R P = (Rd + Rf ) ( Pd + Pf )
B = Rf - Pf
(since Rd = Pd)
For an open economy, the total receipts may differ from the total
payments and their difference represents the difference between foreign
receipts (Rf) and foreign payments (Pf). The positive difference is termed
as a surplus while the negative difference is termed as a deficit in the
international balance of payments of a country.
The balance of payments of a country is not a balance-sheet showing a
country's foreign assets and liabilities at any given point of time. It
shows, for any given period of time, the flow of a nation's total receipts
from abroad and its total payments made to abroad. Following the
conventional rules of double entry accounting, a nation's total payments
and total receipts for any given period of time must be in balance.
Furthermore, one nation's receipts are payments for others while the
receipts of other nations are payments for the nation.
Usually, a country's external balance of payments distinguishes between
items on current and capital accounts. In the current account are
included all kinds of exports and imports of goods and services, interest
and dividend payments, private gifts, and so on. The capital account,
sub-divided into short-term and long-term capital transfers, lists the
imports and exports of all kinds of debt instruments and corporate stocks
as well as imports and exports of monetary gold. Reparations and other
unilateral transfers are generally listed separately.
Like the domestic transactions, international transactions recorded in the
balance of payments of a nation comprise the total purchases (imports)
and total sales (exports) of goods and services, purchases and sales of
claims and unilateral transfers. The following example explains the
different items included under various subheads in the international
balance of payments of a country.
For the components of the balance of payments position of a country,
see Fig. 15.1 below.
Fig. 5.1: Components of Balance of Payments
Receipts (Credits)
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Payments (Debits)
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MACRO-ECONOMICS
1.
Exports of goods and services:

1. Imports of goods and services:
(a) Merchandise
(a) Merchandise
(b) Services
(b) Services
(c) Income from foreign investments
(c ) Foreign income from
investments made at home
2.
Sales of long-term claims:

(a) Equity claims
(b) Debt claims
2.
Purchases of long-term claims:

(a) Equity claims
(b) Debt claims
3.
Sales of short-term claims:

(a) Against deposits
(b) Others
3.
Purchases of short-term claims:

(a) Against deposits
(b) Others
4.
Sales of gold
4.
Purchases of gold
5.
Unilateral receipts
5.
Unilateral payments
6.
Errors and omissions
6.
Errors and omissions

1.
2.
Explain the term balance of payments.

Mention the components of balance of payment.
3.3
Importance of Balance of Payments
The international balance of payments, which is a quantitative summary

of a country's international financial transactions over a given period of
time, reveals various aspects of a country's international economic
position.
The international balance of payments of a country furnishes
information about the international economic position of the country.
Such information helps the government in taking decisions regarding
monetary and fiscal policies on the one hand and on trade and payments
issues on the other.
The balance of payments is also used to determine the influence of
foreign transactions on the level of national income. In the case of an
underdeveloped country, the balance of payments shows the extent of
dependence of the country's economic development on the financial
assistance given by the developed capital-lending countries and international financial institutions such as IMF, World Bank and IDA.
In the case of an advanced country, financially well off, having far-flung
foreign investments and receiving a large income flow in form of
dividend and interest income, the balance of payments can show the
extent to which its citizens are living on their past exports.
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Basically, the most important significance of the study of a country's

international balance of payments lies in its being an indicator of the
changing international economic position of a country.
The balance of payments is an economic barometer which if properly
handled by an economic analyst, can be used to appraise a nation's
short-term international economic prospects, to evaluate the degree of its
international solvency, and to determine the appropriate foreign
exchange rate of the money unit of a nation.
Discuss the importance of balance of payments.
3.4
Shortcomings Inherent in Balance of Payments
Notwithstanding that a country's international balance of payments

serves as its economic barometer, there are many things which cannot be
known by a mere study of the balance of payments.
1.
A favorable balance of payments position is not always a sign of

the economic prosperity of a country nor is adverseness of a
country's international balance of payments always an indicator
of a country's economic bankruptcy.
2.
A balance of payments deficit per se is not the proof of the

competitive weakness of a nation in foreign markets. One would
need to know a good deal more about the causes and prospects of
the deficit. The longer a country's balance of payments "deficit
continues, however, the more it would seem to point to some
fundamental difficulty.
3.
Similarly, a favourable balance of payments position should not

always make the government of a country complacent because a
poor country may have an unfavourable balance of payments due
to massive inflows of foreign loans and equity capital or a
country may have favourable balance of payments resulting from
speculative foreign capital inflows in anticipation of appreciation
of her money unit.
4.
Similarly, an economically strong nation like the United States of

America may have an adverse international balance of payments
resulting from the massive assistance she may have given to poor
debtor nations. A debtor and economically backward nation at the
time of receiving foreign loans will normally enjoy a favourable
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balance of payments position while a creditor country may have

an unfavourable balance of payments position at the time of
giving foreign loans or making investments abroad.
5.
A deficit or surplus balance of payments of a country per se is not

an infallible index of the economic bankruptcy or prosperity of
the country because a deficit balance of payments (in the case of
a creditor nation) is compatible with economic prosperity and
provides no cause for national alarm while a surplus balance of
payments (as in the case of a debtor nation receiving loans) does
not always indicate sound economic condition of the country.
6.
Furthermore, the balance of payments does not give information

in sufficient detail to be useful. It is only insufficient material that
is made available about the short-term capital movements of the
period, and in some cases it may be very important to distinguish
one kind from the other. Apart from this, the balance of
payments, as it is generally prepared by some countries, does not
give the breakdown of transactions by reference to the countries
with which they have taken place.
7.
The main difficulty is that a country's balance of payments deals

only with the transactions of the period under review. It does not
provide data about the assets and liabilities that relate one country
to others. It is not possible to determine from the balance of payments the debtor-creditor status of one country in relation to
another or others, although it is possible to know the changes in
that status during the period in question.
8.
The balance of payments of a country does not tell the whole

story; at best it tells only a part of it. Therefore, it is essential to
have an analytical mind in order to get facts out of the bald
statistics contained in the balance of payments. To get a correct
idea of the true picture of a country's economic situation it is not
enough to know whether her international balance of payments is
deficit or surplus; one must go deeper and find out the causes
which have occasioned the deficit or surplus in the international
balance of payments of the country.
All the foregoing criticisms notwithstanding, a country's international

balance of payments can, however, provide us with some information
vital to our understanding of that country's economic dealings with other
countries. It shows us, for instance, the composition of these dealings,
the flows of goods and services and changes, if any, in the country's
status as a debtor or creditor in relation to other countries.
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MACRO-ECONOMICS

Identify and explain the shortcomings inherent in balance of payments.
3.5
Causes of Disequilibrium in Balance of Payments
Disequilibrium in the balance of payments position of a country may

arise due to various reasons.
1. It may be due to those factors which may simultaneously worsen a
country's balance of payments position and reduce income in the

country and vice versa.
2. It may also be due to such factors which while raise the level of
national income in the country, deteriorate the balance of payments

position of the country and vice versa.
There may be some other factors which while cause disequilibrium
in the balance of payments position of a country, leave the level of
income unaffected.
3.
4. The balance of payments disturbance arising from a shift in the

foreign demand away from one country's products to another's
because such a shift causes similar changes in a country's balance of
payments position and the level of income.
5. Similar disequilibrium in the balance of payments of a country will
also be caused by international capital movements, e.g., balance of
payments disequilibrium caused by differences between different
countries' costs or rates of price rise.
6. Another consideration refers to those disturbances in the balance of
payments which while leaving a country's current account
unaffected, affect only its liquidity position. These disturbances arise
from the domestic or foreign wealth holders' desire to change the
composition of their assets portfolio in such a manner so as to
increase their holdings of foreign securities.
7. The desire on wealth holders' part to increase their total holdings of
foreign government securities and corporate shares will increase the
pressure on country's external balance of payments; increasing its
deficit in the process.
Mention and explain the causes of balance of payments disequilibrium.
3.6
136
Removal of Disequilibrium in Balance of Payments
ENT 108
MACRO-ECONOMICS
Disequilibrium in the international balance of payments of a country

indicates a state of imbalance between autonomous international
payments (demand for foreign exchange or currencies) and receipts
(supply of foreign exchange or currencies).
Removal of this disequilibrium means a change in the relationship
between the payments and receipts sides of the ledger so that the two
sides become equal. To remove a deficit in the balance of payments of a
country, autonomous receipts must expand relatively to payments while
to eliminate a surplus position, payments must expand relatively to
receipts.
In short, the adjustment between receipts and payments in a country's
balance of the payments requires necessary changes in those variables to
which the payments and receipts are functionally related. A complete
list of all these variables embraces the economic universe since all the
parts of an economic system are interrelated.
Attention may, however, be confined to only the key variables. These
key variables in the case of the balance of payments of a country are the
foreign exchange rates, prices of internationally-traded goods and
services, levels of income and government control over international
transactions. Any change in any one or more of these variables will
materially affect the position of the balance of payments of a country on
account of their strong functional relationship with autonomous
international payments and receipts. Assuming that the disequilibrium in
the external balance of payments position of a country is of the deficit
variety we can discuss the adjustment of the balance of payments
disequilibrium through different methods.
1.
Change in Foreign Exchange Rate
Disequilibrium in the balance of payments is a state of imbalance

between the total demand for and the total supply of foreign exchange
revealed by the existence of either excess supply of or excess demand
for foreign exchange at any given rate of foreign exchange.
Ceteris paribus, if at any given rate of foreign exchange the balance of
payments of a country is in disequilibrium, equilibrium can be restored
by making appropriate changes in the foreign exchange rate such that
while the demand for foreign exchange (imports) decreases the supply
of foreign exchange (exports) increases thereby eliminating the deficit
gap in country's external balance of payments.
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MACRO-ECONOMICS
Ceteris paribus, if the foreign exchange rate is higher in a country, the

prices of her exports will be lower in the foreign markets while the
prices of her imports will be higher. This will strengthen the competitive
position of the country as a seller of her goods in international markets.
The degree to which the balance of payments deficit will be reduced as a
consequence of a given changedevaluationin the foreign exchange
rate will depend upon the price elasticity of domestic demand for
imports and on the price elasticity of foreign demand for a country's
exports.
2.
Change in Prices
Change in the prices of the countrys commodities can be used in

correcting the balance of payments deficit. Changes in the relative
national prices could be achieved through the differential rates of
absolute price changes at home and abroad, keeping the foreign
exchange rate stable.
The extent to which price changes can remove balance of payments
disequilibrium depends upon the price elasticities of demand for imports
at home and abroad. The balance of payments deficit of a country will
be eliminated or improved as a consequence of price fall if the price
elasticities of demand for the currency-countrys imports and exports are
high.
3.
Change in Income
Autonomous balance of payments transactions are also functionally

related to income. Ceteris paribus, higher income at home leads to
higher imports while higher income abroad will cause an increase in the
exports of the country. Consequently, a deficit in the balance of
payments of a country may be corrected through either a decrease in
national and personal incomes at home or through an increase in
national and personal incomes abroad.
The degree of responsiveness of imports and exports to changes in
income at home and abroad, is measured by the marginal propensity to
import or by the income elasticity of demand for imports. The marginal
propensity to import is the ratio of change in imports in response to an
infinitesimal change in income.
In measuring the ratio of relative changes in imports to changes in
national, the income elasticity of demand for imports is the most
appropriate concept. It may be defined as the percentage in total imports
divided by the percentage change in national income. It is given as:
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ENT 108
MACRO-ECONOMICS
RI = Marginal Propensity to Import

Average Propensity to Import
National income and balance of payments of a nation are intimately
related with one another such that changes in one cause changes in the
other.
There are other measures which can be employed by a country to correct
balance of payments disequilibrium. These include ban on importation,
imposition of quota, imposition of import duties, reduction in export
duties, etc.
Mention and explain means of correcting balance of payments
disequilibrium.
4.0
CONCLUSION
From the foregoing analysis, you can understand the meaning of both
balance of trade and balance of payments, and their differences. You can
also appreciate the importance of balance of payments and its inherent
shortcomings. Furthermore, you can also understand the causes of
disequilibrium in balance of payments and some of the ways through
which such disequilibrium can be ameliorated.
5.0
SUMMARY
This study unit has been used to discuss the meaning of the balance of
trade. Also in this unit, the meaning and components of balance of
payments discussed. Furthermore, the inherent shortcomings in the
balance of payments are discussed. Lastly, the unit also discusses the
causes of disequilibrium in balance of payments and the means of
obliterating the balance of payments disequilibrium.
This study unit happens to be the last unit for the course. The
expectation is that you might have read and digested the preceding study
units before coming to this unit, which is used to conclude the analysis
of the course.
6.0
1.
2.
Explain the term balance of payments.

Mention and explain the causes of balance of payments
disequilibrium and how it can be ameliorated.
139
ENT 108
7.0
MACRO-ECONOMICS

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NATIONAL OPEN UNIVERSITY OF NIGERIA

SCHOOL OF BUSINESS AND HUMAN RESOURCE

COURSE CODE: ENT 108

COURSE TITLE: MICRO ECONOMICS

NATIONAL OPEN UNIVERSITY OF NIGERIA

National Open University of Nigeria

National Open University of Nigeria

The course contents consist of national income, consumption, saving

explaining the meaning of national income;

explain the meaning of national income;

explain the importance of financial institutions to any economy;

Multiplier, Accelerator and Aggregate

Final Examination and Grading

NATIONAL OPEN UNIVERSITY OF NIGERIA

National Open University of Nigeria

National Open University of Nigeria

Multiplier, Accelerator and Aggregate Level of

At the end of this unit, you should be able to:

explain the meaning of national income

Meaning of National Income

National income is regarded as the market value of all goods and

Concepts of National Income

Gross National Product (GNP)

Gross Domestic Product (GDP)

It refers to the value of total output of goods actually produced in the

Net National Product (NNP)

This is regarded as national income proper. It refers to the sum of all

Personal income is the total national income of a particular country or

individuals due to their contribution to the productive sector of the

Accounting Relationships in National Income

Relations at Market Price

Relations at Factor Cost

The Significance of National Income Analysis

It reflects the extent to which goods and services are valued in

The GDP explains the overall contribution of the various

SELF ASSESSMENT EXERCISE 3

Identify and discuss the various concepts associated with national

Begg, D., S. Fischer and R. Dornbusch (2000). Economics, Sixth

DETERMINATION OF NATIONAL INCOME

In the preceding unit, you have been introduced to the meaning,

At the end of this unit, you should be able to:

mention and explain the three approaches for measuring national

National income is measured through the income approach by adding up

the national debts and to individuals. Therefore, national income can be

More often, a substantial portion of income generated by business

Absence of Rent Payment on Owner-occupier Houses

Houses occupied by their owners do not attract rent payments. This

Goods Produced and Consumed by Producers

An underestimation of national income involves some goods and

Absence of Definite Remuneration for Self-Employed People

Some individuals who are self-employed do not claim definite wages or

individuals on wage or salary basis. These types of people do earn

Explain the income method of national income estimation.

This approach to measurement of national income, involves estimating

Risk of Double Counting

This arises due to the interrelationships between and among

Omission of Unpaid Services

Some activities, especially services whose value is supposed to be

The identification of some self-service activities is not easily realized.

Explain the output method of national income estimation.

private consumption expenditure;

consumer goods and services;

consumption expenditure, investment